Asset prices have risen back to levels that match fundamentals, but returns are not as high as they used to be.
The increases in stock prices over previous years, combined with bond prices that remain high (yields are low) have raised the possibility of mispricing in assets, potential bubbles and future crashes. Are all assets too expensive? Some think so and refer to the current situation as a "gigantic financial asset bubble" where all assets (bonds, stocks, commodities) are priced too high. Others see trouble just in stock markets where valuations seem to be growing much faster than the real economy. But there are also those who think the stock market still offers a good return.
Here are two perspectives that can hopefully help us understand such diverging views on asset prices:
1. How can it be that all asset prices are overvalued? When all asset prices look too high, we are making a statement about the disappointing returns these assets offer. The key question is whether we are really talking about mispricing or simply about surprisingly low (equilibrium) returns that saving is offering these days? Martin Wolf in the FT offers many arguments on why low interest rates are here to stay because in a world of abundant saving, returns will be low and asset prices will be very high (I have written about this before). So maybe all asset prices are not too high, it is just that returns are not as high as they used to be.
2. How do you define a bubble? Before answering the question, it is good to get a perspective on the data. Neil Irwin at the New York Times has a great summary of the US stock market in six charts. What do we learn? Stock prices compared to the current level of earnings are high by historical standards. In other words, if you buy the stock market today, you should expect returns that are lower than typical returns. Is this a bubble? Maybe not if those low returns are consistent with the low returns that are offered anywhere else in the economy (back to the argument that "all asset prices are high"). If you do that comparison (see Irwin's article) and calculate the difference between returns one would expect from current stock prices and the returns that bonds offer, the difference is still positive and consistent with historical values (this is the same point that Brad DeLong makes). So stock prices look high but so do every other asset price. Once again, get used to low returns in a world where everyone wants to save.
So does it mean that everything is fine? No, it all depends on what the expectations of current investors are. A bubble in the stock market is not about how high stock prices are or about how low expected returns are. A bubble is about expected returns that are inconsistent with the current stock prices and their relationship to the fundamentals of the economy. If investors are buying stocks today having the returns that we have witnessed in the last years as a reference, then we are in a bubble. But if investors are buying stocks today as an investment that offers a low but consistent return with any other form of saving, then we are fine. From Irwin's article at the New York Times:
"Add it all up, and it leads you to a conclusion. Stocks may not be wildly overvalued relative to fundamentals. But for them to rise much from here, a lot of things will have to go just right for investors."
Correct. Stock are not a bargain like they were two years ago (when risk aversion was very high). Their prices are back to levels that are consistent with fundamentals and those fundamentals can deliver returns that are reasonable given other investment opportunities. But if all your fellow investors are hoping for yet another great year in the stock market, then run, because there is no way fundamentals can justify another couple of years of very high returns.