Something interesting is happening in equities and housing markets. Prices look bubbly to a lot of commentators, who are throwing their hands up in confusion. Stocks must be overvalued, overdue for a correction. Housing will correct too, presumably. The question on everyone’s mind: what the hell is going on?
There are a couple theories out there based on different mental models. First of all, there’s what I’ll call the interest rate theory. Because interest rates are low, in the hunt for yield investors are seeking out riskier assets. This pushes up the values of stocks and houses. Even Warren Buffett appears to support this view. On treasury rates, he reportedly said “I don’t start salivating, let’s put it that way.”
Move a step beyond the interest rate theory, and you get the bubble theory. While you don’t have to believe there’s a bubble to think interest rates affect asset prices, there has been a lot said on the Fed’s ZIRP policy blowing bubble after bubble. In this mental model, the Fed, in its quest to support the economy, just ends up pushing asset prices beyond any reasonable valuation. In this corner there seems to be less acknowledgement that the Fed can create inflation where it wants to. Instead it ends up with a lopsided balloon animal. Blowing in one part is just inflating somewhere else.
A third theory is the efficient market theory. The reason it’s so hard to beat the stock market is because it’s a Bayesian machine. To explain, Bayesian logic uses what we know to predict the future. Nate Silver famously uses Bayesian logic to predict the outcomes of elections. The way it works: say you know Barack Obama won Ohio last election. That means the Democrat is likely to win it next time. If all the polls show her ahead, that will bring up the % chance that she wins Ohio. If all the sudden an outlier poll puts her opponent up, the rest of the media will go mental, but a Bayesian model will simply incorporate it into everything else it knows. Voila, Silver predicts elections very well indeed.
A stock market is the same thing. Every fact known about a particular company adds into a stock’s valuation, including economic forecasts. So whatever we collectively know about the economy and a company are already factored in. Which is why it’s so tough to beat the market.
A bubble, or a mania, happen when, instead of looking at a mix of fundamentals, a psychology of only looking at price increases takes over. Instead of saying company X will generate 10% return to me based on cash flow, and looks like it has a strong moat, you instead say company X increased in price by 20% last year. That means it will keep going up regardless of cash flow or the economy or whatever. Eventually these bubbles collapse.
What’s strange in the case of the stock market and housing is that they seem to be reflating rather quickly. We recently had an internet stock bubble in the late 1990’s, and we just went through the housing bubble in the mid 2000’s. In the past, when the market for something crashed after a mania, that would give the players some inoculation against a future mania (after all, people aren’t that stupid, are they?). That doesn’t seem to have happened as home/stock valuations bounce back to where they were pre-crisis. For stocks we know the story. From Zillow, the below data show, in most states, we’re back to 80%-90% of peak (maybe there was a real bubble in Nevada, Florida & Arizona).
What does this say about our three models? It suggests that we’re not actually reliving a bubble in stocks and housing. In fact, it appears as though investors are behaving quite rationally with the risk-free yield on offer. If you buy a house with a mortgage, your debt service will be quite low. If you buy a house with cash, you’ll earn a decent % yield in terms of rent (much more than a 10-year treasury). If you buy good-dividend-paying stocks, you’ll handily beat treasuries while also buying insurance against future inflation.
There are really two choices for any investor facing the market now. 1) You know more than the market, which represents the collective wisdom of millions of analysts, economists & investors. If you start betting that there’s a bubble, you’re saying that most investors are complicit in a mania. 2) The market knows more than you. Sure, there may be areas that look overvalued (social media stocks, anyone?), but with all the information available, the market is behaving rationally.
My feeling is that there is a feedback-loop effect happening. The economy is growing strongly, and seems set to grow strongly for a while. The Great Recession was so deep that we have a ways to go before we hit a wall with higher inflation. The Fed finally seems to understand this, and is willing to let the economy reflate. That means strong growth combined with low interest rates for the near future. What is the rational thing to do in those circumstances? Buy assets.