Ever since the collapse of the housing bubble in 2007–2008 that gave us the Great Recession, there has been a large doom and gloom crowd anxious to tell us another crash is on the way. Most insist this one will be even worse than the last one. They are wrong.
Both the housing bubble in the last decade and the stock bubble in the 1990s were easy to see. It was also easy to see that their collapse would throw the economy into a recession since both bubbles were driving the economy. We are in a very different place today.
The stock market is high. By any measure, price-to-earnings ratios are far above historic averages, but they are nowhere near as out of line as they were in the 1990s bubble.
The current value of the market is roughly 24 times after-tax corporate profits, based on the first quarter’s data. This compares to the historic average ratio of 15-to-1. But at the peak of the bubble in 2000, the ratio was over 30-to-1.
Furthermore, the higher than normal price-to-earnings ratio can very well be justified by unusually low real interest rates. The interest rate on the 10-year Treasury bond is flirting with 3.0 percent. With a 2.0 percent inflation rate, that translates into a real interest rate of just 1.0 percent.
By contrast, when the stock market was soaring in the late 1990s, the yield on 10-year bonds was generally over 5.0 percent. Given an inflation rate also near 2.0 percent, this translated into a real interest rate of 3.0 percent. That made bonds a much better alternative in the 1990s bubble than at present.
It is true that profits are unusually high as a share of national income. This reflects a big increase in the profit share in the weak labor market following the Great …read more