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Is there an echo bubble?

The Dow is at 9674, almost back at the 10,000 level. To be fair, the S&P 500 is really a better indicator of the U.S. stock market because it includes the entire gamut of companies that people invest in. The S&P 500 is at 1038, which is down 32% from its peak of 1527 back in March of 2000. Nevertheless, 1038 represents a 34% increase from its trough of 776 only a year ago in October 2002. A 34% return over a one year period is a pretty darn good return!

Non-investing types' eyes may glaze over when I write about the stock market levels, but this is something that all should be concerned about. Stock values are often an indicator of how the economy as a whole is doing, because high values create a wealth effect, and high stock values also mean that there is a lot more capital available for companies to spend, and when companies are spending money we have high employment and everybody is happy. There is no doubt that the booming economy we experienced in the late 1990s was a result of the rising stock market. And the painful economy of the last few years has been a result of the falling stock market. (This correlation leads some people to the wrong conclusion that we need to "pump up" the stock market in order to have a healthy economy--this might be the topic of a future post.)

Yale economist Robert Shiller, in his book Irrational Exuberance, examined the PE ratio of the S&P 500 based upon ten year trailing earnings numbers. In January 2000, right before the book was published, he showed that this ratio was at an all time high of 44.3. In 1929, the ratio only reached 32.6. He also showed that at the troughs of bear markets, this ratio would fall below 10, which happened after the 1929 peak, and also after the 1966 peak (reaching rock bottom valuations in the early 1980s).

If history is to repeat itself, then the U.S. stock market is in for an extended bear market, and the stock price increases we've been experiencing during the last year have merely been an echo bubble. The same conclusion was reached by blogger Karsten in his CurryBlog.

However, it's always possible that things really are different this time, and that the stock market going forward will have permanently higher valuation levels than in the past. The basis for this could be all of those 401K programs. Never before have so many Americans become stock market investors. Even through the bear market, the majority of Americans still put their 401K money into stock mutual funds. This auto-pilot investing surely helps to pump up the prices of U.S. equities.

posted Sunday, October 12, 2003