Yet another bubble
A geographically distant reader asked me today:
Maybe you can explain why, despite high unemployment and cratering real estate, the stock market has skyrocketed this year. Our church’s weekly contributions are suddenly off 25%, so I’m concerned something broader is going on. Thoughts?
His message comes at an interesting time, as local businesses tell me the same. The owner of the local dry cleaner, who has predicted economic trends for the past 25 years by watching foot traffic out his window, tells me things have fallen off another cliff since September.
Corporate earnings from summer 2007 to spring 2008 suffered a 92% decline — the most abrupt in U.S. corporate history — yet share prices act as if all is well. Why?
There are really just two possible explanations. Either the market is pricing in a nominal recovery (meaning either a real recovery or massive inflation), or we are in another asset bubble.
I suspect the latter, because the market’s P/E ratio — a basic yardstick priciness — is at an all-time high, by far, while there is no evidence of price inflation, and little evidence of recovery.
The following indicators are at, or near, the worst on record, and still worsening:
- Consumer spending.
- Personal bankruptcy.
- U-6 unemployment.
- Mortgage delinquency and default.
- Consumer credit growth.
Those are off the top of my head. The list is endless.
We may see some form of “recovery” in the next few months, such as stabilization at the new, lower levels. This does not justify the dizzying heights of current share prices.
A hypothesis widely circulated among other finance and economics blogs, which makes sense to me, is that capital simply has nowhere else to go but the capital markets. Consumer cannot borrow more — they are struggling to pay off the debt they have. Business investment is way down, worldwide, because there is overcapacity in almost every capital asset.
Instead, capital flows to where there appears to be a high short-term return: equities and commodities. In sufficient quantity, and coupled with the momentum-driven strategies that dominate high-frequency trading, this causes equity prices and underlying value to decouple. This decoupling is known commonly as a “bubble.” Perhaps you’ve heard of it.
For the past 10 years, the common factor of all asset bubbles has been excessively loose credit, both artificially low interest rates and artificially easy lending practices.
This appears to be happening again with finance sector rescue programs from the Fed and Treasury — i-banks and lenders simply convert to bank holding companies, whence they can borrow at zero, on easy terms, and put the money anywhere they want. There are few rational places to put it, so there is incentive to put it in irrational places. So the S&P goes to 140 times trailing earnings.