The Dow Industrials, the Standard & Poor's 500 and the NYSE Index are all at record peaks. The amount of margin debt being used to purchase stocks on the NYSE is at a record high also (see chart). And the expectation of record low interest rates for some many months to come, primed by the Fed's purchase of bonds and mortgages, promises to many that the returns in the stock market are not about to diminish anytime soon.
Credit: Barry Ritholtz, Fidelity.
As well, stock indexes across the globe also have the benefit of easy money; Japan's Nikkei is up 35% this year, 50% more than the S & P 500, up 23.4%, Germany's DAX, a gain of 18%, France's CAC, 17%, and the FTSE in the UK, 14%. Is this a new utopia, or the makings of a bubble in the stock market? All those many investors, who had not a clue about the oncoming bubble in home prices in 2006, must be plainly worried about the tremendous surge in common stock prices due in great part to the prime pumping of central banks everywhere.
Consulting some of the most astute bubble analysts led us to a brilliant woman economist, Sarah Bloom Raskin, a Governor of the Federal Reserve, who gave a most clairvoyant talk in July at the Exchequer Club Luncheon in Washington, D.C. where she laid out the stepping stones for an asset bubble and admitted that they are very difficult to predict. "While we may not be able to predict bubbles, we understand them to be a product of particular actions and choices by financial institutions and their regulators," she said.
For example, a bubble can start in a low interest rate climate like today where investors borrow money to seek higher yields by purchasing some specific higher-yielding asset, and once those assets rise in value these investors or others who are drawn in, might borrow even more money on the higher valuation, which usually makes these same assets climb even more in value. Presto! You have created a record amount of debt at what seems a bargain in the very little interest rate you are paying. You have also raised the problem of huge unstable short-term lending, from sources such as uninsured deposits, commercial paper or repo transactions in order to fund the loans.
Does this sound familiar? It should remind you of 2007-2008 when massive short-term borrowing was going to leverage up massive amounts of unstable long term mortgages and derivative contracts packed with these unstable long term mortgages. In other words, "bubbles are characterized by increased leverage" and when those assets being leveraged, be they stocks or mortgages, are about to lose a meaningful portion of their value, all that debt is very hard to pay back. Presto! You are in a crisis about to turn into a panic of seeking liquidity.
"Indeed," said Ms. Raskin, "a dramatic decline in the price of a significant asset can reduce household wealth, spending and aggregate demand. When such effects on wealth, credit availability and aggregate demand are large enough, the real economy can suffer a significant recession. And, of course, lower employment and incomes further depress asset prices and borrowers' ability to repay loans, with further adverse effects on financial institutions and their ability to extend credit."
So, is today's stock market, selling at only 15 times expected earnings, by no means a peak multiple of corporate profits, in any way similar to the boom and bust in housing where home prices plunged on average 30% throwing the financial system into chaos? (A reminder that stocks also lost close to half their value as they were liquidated by insolvent, soon to be bailed out financial institutions.)
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