With oil hovering near $50 a barrel, markets at record highs and Fed tightening in sight, a lot of smart people are predicting a crash. I even did a blog post not long ago on whether American stocks were overvalued. I don’t think so.
Let me explain why. During periods of slow nominal GDP growth (periods that seem like loose monetary policy, but are actually quite tight), the ratio of stock prices to nominal GDP goes up. Since the mid-1980’s we’ve seen the Fed tighten and tighten to cram inflation into their 2% goal. There were variations to be sure, but the secular trend has been slower and slower nominal GDP growth.
Why should that affect stock prices? Because slower NGDP growth = lower interest rates = the opportunity cost of buying stocks goes down (ie. you could buy bonds). Put another way: in the 1970’s a safe, 2% dividend stock was a pittance. Now 2% isn’t half bad.
Yes, if hyperinflation happens (any day now, right?), then stocks will crumble. But the Fed has done little to reset our future expectations of inflation. In fact, they seems pretty stuck on 2% as their limit. They have been good about making sure we don’t expect inflation to go much lower than 2% (hence we have much stronger growth than in Europe where the ECB seems completely bereft of any tool with which to reset their own expectations), but the giddy years of 10-12% NGDP growth seem quite far away.
What can we conclude? Monetary policy remains tight (especially with QE ending). Therefore we won’t escape low NGDP growth anytime soon. Therefore we will continue to have low interest rates over the next couple years. People follow incentives, keep buying stocks, and those 2% dividends won’t look half bad.