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Are we reliving the bubbles of the last 20 years?

March 17, 2015 by Leave a Comment

In the late 1990’s, the internet bubble inflated and burst. In the mid 2000’s, we watched housing prices inflate and burst, along with stock prices again. Since 2009 we’ve watched stock prices climb higher and higher, and we’re left wondering, now, are we’re reliving past bubbles? Or are we at a fair valuation considering low interest rates / low inflation?

It depends on your answer to this important question: are markets rational? A lot of people smarter than me think the stock market is like a Bayesian machine. Every new piece of information is incorporated into a pretty good forecast of future economic activity. When a supposed bubble bursts, it’s interesting to note that, historically, the market has always recovered to find new highs. And the fall always predicted a recession (read more in this fascinating paper by Eugene Fama).

Rather than viewing market swings in terms of irrational exuberance, we should rather think of them as rational predictions of future economic growth. Of course “Mr. Market” changes his mind a lot, but that’s because the flood of information coming every day gives him evermore to chew on. More jobs? Maybe the Fed will choke off economic growth with tighter monetary policy. Lower interest rates? Maybe stocks should adjust higher because the rate of return from safe securities is too low. Even lower interest rates? Maybe stocks should tank because inflation expectations have dropped dangerously low, signalling another collapse in demand like we had in 2008.

A bubble to me represents a psychological mania devoid of all rationality. The internet stock bubble fits this description. Geocities was never going to be worth $3.6 billion. Pets.com was never going to be worth anything. Instead of focusing on revenues and future potential profits, a bubble feeds off past price increases only.

As housing prices and stock PE ratios approach past peaks, we need to have the proper economic mental model. Instead of thinking in terms of unsustainable bubbles, we should think of stocks and housing being more like the old game “pong”. Each paddle is good news / bad news about the economy. When there’s good news, the ball moves in one direction until bad news pushes it the other way. Like an object in space, it will only change direction if opposed by an opposite force.

There is some tea-leaf reading we have to do. Low interest rates can mean expected easier Fed policy (good) or dangerously low inflation expectations (bad). With stock prices shakier, what do the tea leaves tell us? Is the bubble is about to burst? Perhaps, but it’s far likelier that recent unease is related to fear that the Fed will tighten too soon, and we’ll relive the collapse in nominal growth that happened in 2008.

Unfortunately most commentators believe Fed policy to be ultra loose right now, so you won’t find this interpretation in many other places. But even Milton Friedman explained that low interest rates were more than likely a result of too-tight monetary policy. When treasury rates drop along with stock prices (as they have done this week), it’s time for the Fed (and investors) to beware. It’s not a bubble bursting, but a failure of monetary policy that may destroy stock prices in the near future.

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