On the Fears of Bubbles

Katharina recently posted some of her thoughts on the developments in asset markets since the start of the FED’s different unconventional monetary policy programs. I honestly do not know how to go about answering the post, as I personally am unable to get much out of the FT report. But let me give it a try. A couple of months back I posted something dubbed “How destructive are asset bubbles really?”, which I find myself still mostly agreeing with. Of course a lot of that argument is based on monetary policy being able to be effective, which might be somewhat limited given we’re up against the ZLB, but right now is not the place to go into that discussion again. When it comes to identifying whether a bubble is indeed forming or not, I shared some of my thoughts in this post on “The Science of Bubble Spotting”, which probably provides a decent starting point to build on. So let’s get into it.

First of all, bubbles are generally characterized by building up exponentially, of which I do not see much of even in the stock market. The level of the stock market is not necessarily what I would argue we should be looking at either. If you want to spot bubbly behavior, the deviation from trend is generally much more useful than any level measure, and as far as I can tell, the trend in the rise of the S&P500 is fairly linear. In any case, what’s the argument behind the correlation between stock prices and the FED’s balance sheet, anyways? First of all, if you run a regression through the two, the slope of the S&P 500 curve is steeper than that of the FED balance sheet’s curve, meaning that QE does not explain everything. But even if the stock market was somehow “tied” to the level of the FED’s balance sheet, why would this be much of a problem? If the argument is that monetary policy is ineffective because it just blows up stock prices without doing much for the real economy, meaning that the FED can’t influence the real economy by pushing stocks up, why should it be able to influence the real economy by letting stocks drop again? Why should this process by asymmetric? And if it’s not, either it does not matter what the FED does or it actually matters quite a lot. In any case, the FED should keep at it. Will the stock market keep rising? No one knows. Does it matter for the real economy? Probably not.

As to other stock market indicators that are often cited as showing that there is a stock market bubble, such as the price/earnings ratio, I must admit I never understood most of them. How does it make sense to compare the price of a stock, which by definition is not much more than present value of (expected) future incomes, i.e. a forward-looking measure, with the earnings per share of that stock, which by definition is a strictly present-based measure (or slightly backward-looking, if you use those of the previous quarter). Maybe it makes sense to compare different stocks based on this, but I’m not sure how this measure applied to the entire market is of any use for our purpose at hand. But then again, I’m an economist and not a financial analyst, so what do I know. Robert Shiller seems to somewhat think it matters, but he also says its of no use as a timing-mechanism. As to the rising profit share of GDP, I find globalization to be at least as compelling an explanation for what has been happening in the last years as any fears of the FED being behind this. Also, GDP is depressed. A high profit/GDP ratio can just as well mean that the denominator is too small.

Also, as in the posts I linked to, asset prices generally don’t seem to be very good indicators to spot a bubble. In general, what you want to be looking at is credit growth, and on that front I am more than unimpressed. Below is a chart showing commercial and industrial loans, which have somewhat recovered but seem to actually be slowing as of lately. I must admit I do not understand Mr. Lee’s “corporate leverage ratio adjusted by profit share”. Maybe I’m missing some statistics here, but from my reading of the data I would not know where companies would be getting their leverage from.

As a last note something on the “huge bond bubble” I keep hearing about elsewhere. If there indeed is a bond bubble, it is a result of tight money, not easy money. Bond prices relate inversely to their yields, and their yields are low because overall interest rates are low. Overall interest rates are low because we are in a depressed economy, and we are in a depressed economy because money has been too tight. So if anyone wants the FED to “stop blowing up a bubble in the bond market”, they better follow that up by asking the FED to blow more money into the economy, not less, otherwise their statement doesn’t seem to make much sense.

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