Monday, May 20, 2013

Are we in a stock market bubble?

The S&P just breached 1600, an all time high. Are we in a stock market bubble?

(Please indulge me in a brief aside. This image of the S&P from the 1970s is depressing). Basically, the stock market has gone sideways from the internet boom of the mid-90s to today. In the last decade, there have been two brutal downturns, and the extreme volatility you see in the charts, against a backdrop of sideways drift, should make anyone wonder whether investors, as opposed to speculators, really have any business being in this HFT driven market. But I digress. Let me segue back to the point of this post and talk about whether we are currently in a bubble or not).

James Surowieki tackles this in his latest New Yorker post:
With the stock market setting new highs on a nearly daily basis, even as the real economy just slogs along, there seems to be one question on everyone’s mind: are we in the middle of yet another market bubble? ...

The bubble believers make their case with a blizzard of charts and historical analogies, all illustrating the same point: the future will look much like the past, and that means we’re headed for trouble... The bears admit that corporate profits are high, which makes the market’s price-to-earnings ratio look quite normal, but they insist that this isn’t sustainable... Today, after-tax corporate profits are more than ten per cent of G.D.P., while their historical average is closer to six per cent. That’s a vast gap, and it’s why bears believe that the market is, in the words of the high-profile money manager John Hussman, “overvalued, overbought, overbullish.”
All good points. Corporate profits are high, and labors share of income, which has been historically very stable in the US at about 70%, has fallen to just 60%. This is a big deal. Check out this chart, it begins in 1947. So a ratio which has been fairly stable in the US for over 50 years, has fallen off a cliff.

This is the source of rising corporate profits -- there is enough consumer demand to support flat or rising top lines, but a glutted labor market which means that companies can keep compensation costs in-line and increase their overall share of profit. Surowieki cycles through other explanations: corporations pay less in taxes, labor unions are weaker, S&P 500 earnings include overseas operations which are looking to grow, but I think the Labors Share of Income Chart from the Cleveland Fed tells the real story -- a dramatic and recent decrease in labor market strength is flowing through to the corporate bottom line.

So, why? James is coy:
The underlying issue is that in recent decades there’s been a shift in the U.S. economy: it’s become far more congenial to businesses and investors. The fundamental trends that have driven the profit boom are unlikely to be reversed. That doesn’t mean that companies are going to be able to keep slashing their way to profit growth. As Doug Ramsey, the chief investment officer for Leuthold Weeden Capital Management, told me, “It’s hard to see how companies can get profit margins much higher, unless they want to see massive labor strikes across the country.” But keeping profits where they are doesn’t look all that difficult, which makes stocks today quite reasonably priced. It’s still possible that investor hysteria could eventually inflate stock prices, or that investor panic could send them crashing, but there is no profit bubble and, for now, no stock-market bubble, either.
What is this shift which began when the internet bubble popped in ~2000, never recovered, and then took another dogleg down when the debt bubble popped in 2008? Quite simply, I'd say it's a weak labor market because the economy, as a whole lacks aggregate demand. This is not structural, and its congeniality to businesses and investors is accidental, I believe, not calculated. I think that the US Govt has been unwilling to take the necessary fiscal actions, through tax cuts or increased spending depending on your politics, to step in and restore the demand which never really recovered from the internet boom ending.


Blogger blaoism said...

We need to look at overseas operations closely. In BRIC countries, the so-called new middle class pays a huge chunk of their earnings for rentiers in terms of new homes, apartments, etc. The disposable income of these new middle class folks is far less than what these projections make out to be.

Overall, the aggregate demand will be weaker, thanks to self-centered goals of corporations.

3:46 PM  

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