- June 11, 2015
- Posted by: Christopher Thornberg, PhD
- Categories: blog, General Economy
There has been a lot of ‘bubble’ talk lately. Sure, there is the lunatic fringe—such as Ron Paul’s online interview about the coming crash of the U.S. currency, or Jim Rickard’s dire warnings of the impending 25-year depression conveniently laid out in a $25 hardcover book ($13.99 for the Kindle edition!). But now, a number of more conventional voices are getting into the mix. Type ‘bubble’ into Google’s news search and all sorts of stories pop up about stocks, technology, and property bubbles on the verge of popping.
I’ve been receiving a lot of inquiries about the current situation—bubble or not?!—perhaps because of my correct call regarding the fortunes of the U.S. housing and financial markets back in 2006 and 2007. That said, a lot of callers seem surprised as to how sure I am that we are not in a situation I would refer to as a bubble this time around nor is the current U.S. expansion threatened by the trends we’ve seen in asset prices in recent years.
My reasoning is founded on exactly the same logic it was in 2006 and 2007. It isn’t enough to just look at price appreciation. Rather you have to look at economic fundamentals and ask whether they line up with trends in the financial markets. If they do, there is little reason to worry—and right now they most certainly do.
I am not worried about the U.S. financial markets because:
- Asset values are being built on actual performance, not speculation.
- The U.S. economy is not being driven by an excess amount of financial liquidity.
- Trends in the real and financial economy do not suggest that any sector is growing excessively.
In 2006 the exact opposite was true on all three counts.
Consider the first point—that prices are based on performance. The stock market has set record high after record high over the last few years and is far above its previous peak set back in 2008 prior to the meltdown. But this by itself is not evidence of a bubble. Stock prices are determined largely by profits and interest rates. Profits for U.S. corporations are also at a record level—35% higher than in 2007. And interest rates are still very low—10-year bond rates are running roughly 2%. The equity earnings spread—the expected return in the stock market minus interest rates—is still quite high from a long-term perspective. None of this would suggest that the market is overvalued.
A similar argument can be made for home prices. Yes, they have been rising rapidly since 2012. Home prices nationally are within a whisker of their pre-collapse peak, set back in 2007. And some sub-markets are far beyond those record prices. But this doesn’t tell us much. We have to consider what the cost of buying a house is for the average homebuyer. Incomes have been rising over the last few years—admittedly slowly—and even more importantly, mortgage rates have fallen back below 4%. When we look at housing affordability while controlling for these trends a vastly different picture emerges. Home prices have been rising (and affordability falling) but only from the record low levels hit during the worst years of the bust. From a long-term perspective homes are still very affordable—more so than at any time since the early 1990s. This is not a bubble market.
Of course this logic blows away if we consider the potential for a sharp increase in interest rates, bringing us to point two, regarding liquidity and leverage. A lot of doomsayers continue to point to Fed policy over the last few years, which has massively increased the gross monetary base through three quantitative easing (QE) programs. According to these arguments, eventually the liquidity in the system will cause massive inflation, a huge spike in interest rates, and ergo, a massive financial collapse.
It’s true the monetary base has grown by massive amounts—but almost 87% of all the cash ($2.5 trillion) pumped into the system through the three rounds of QE is stored within the Fed itself on behalf of its member banks in the form of excess reserves. This money has no impact on the money supply, interest rates, or pretty much anything else. And this is by design—previous rounds of QE in Japan and the U.S. have showed that most money goes nowhere. If the Fed wants to fight deflation, they have to go big to get enough through to the real economy.
And there is little sign that this cash is going or will go anywhere. Bank lending is growing modestly and is more than well funded by increases in deposits and investor capital. This implies that excess reserves have stayed remarkably stable. And if the banks do start to pull on these reserves, the Fed has plenty of tools to slow things down significantly in order to prevent major problems.
In short, interest rates are low not because of Fed policy, they are low because there is a lot of capital floating around the global economy relative to demand. And with global growth slow, underfunded pensions trying to catch up on their obligations, and Chinese capital fleeing for global markets, there is little sign that this will change for some time.
Lastly there is the real economy—something that is often forgotten in the high debates of finance. By themselves, asset prices going up and down have only a limited impact on the economy. The damage they typically inflict has to do with real flows within the economy that are disrupted as a result of the shift in the markets. For example, the 2001 recession was not caused by the collapse in Nasdaq but rather the coincident collapse in business investment that occurred after the ‘New Economy’ failed to show up after years of record spending. Equivalently the ‘Great Recession’ that began in late 2007 was driven by the collapse in construction after years of excessive building and the massive string of failures on Wall Street due to the dangerous increase in leverage being carried by financial firms.
Today, the U.S. economy does not seem overheated. If anything, it is still struggling to achieve normal rates of growth. The pace of construction remains subdued, consumer spending is at a normal level relative to income, and business investment has been tracking earnings. There is no major overhang in the economy. And the same can be said for leverage as well. The U.S. economy is just pulling out of years of deleveraging in the private sector. In other words, it seems there would be no major financial or real market repercussions from a decline in asset prices.
Just remember this is 2015, and the world changes. Today’s steady-as-she-goes markets could well overshoot the mark in a couple of years. And I have little confidence that the rules put into place by Dodd Frank did much to cool the worst incentives among Wall Street barons. So it could get ugly. But not now. Today, I invest with the confidence of Alfred E. Neuman!