The stock market has recovered sharply from the lows hit in the financial crisis. All the major indices are at or near record highs. This has led many analysts to worry about a new bubble in the stock market. These concerns are misplaced.
Before going through the data, I should point out that I am not afraid to warn of bubbles. In the late 1990s, I clearly and repeatedly warned of the stock bubble. I argued that its collapse was likely to lead to a recession, the end of the Clinton-era budget surpluses, and pose serious problems for pensions. In the last decade I was yelling about the dangers from the housing bubble as early as 2002.
I recognize the dangers of bubbles and have been at the forefront of those calling attention to them. However, it is necessary to view the picture with clear eyes, and not scream “fire” every time someone lights a cigarette.
First, we should not be concerned about stock indices hitting record highs; that is what we should expect. Unless we’re in a recession we expect the economy to grow. If profits grow roughly in step with the economy, then we should expect the stock market to grow roughly in step with the economy, otherwise we would be seeing a declining price to earnings ratio for the market. While that may happen in any given year, few would predict a continually declining price to earnings ratio.
This means that we should expect the stock market indices to regularly be reaching new highs. We need only get concerned if the stock market outpaces the growth of the economy. Outwardly, there is some basis for concern in this area. The ratio of the value of the stock market to GDP was 1.75 at the end of 2014. This is well above the long-term average, which is close to 1.0, and only slightly below the 1.8 ratio at the end of 1999 when the market was approaching its bubble peaks.