Greenspan Sees No Bubble in Dow 16,000

(headline)

Well, that settles it.

Heavy sarcasm aside, we do have the major stock indexes hitting record highs in a still-lousy economy. And thanks to that lousy economy and the Fed’s expansionary monetary policies in response to it, we have interest rates near record lows, which by itself does a lot to raise stock prices. (You can explain this either as borrowing costs to buy stock being cheaper than ever, as the returns on a major stock substitute [bonds] being at record lows, or as the low interest rates raising the intrinsic, or present discounted, value of future stock earnings. These explanations are not mutually exclusive.) But does that make the current stock market an out-of-control bubble? The Fed has cut interest rates many time over the decades without creating stock bubbles. Let’s take a closer look.

Since there is normally some inflation in the economy, a better way to look at stock prices is to adjust them for inflation. J.C. Parets has done this. His index was last updated for Sept 2013, at which time the real (inflation-adjusted) S&P 500 index was 1729.86 (these numbers seem to be in 2011 dollars). Parets emphasized that this amount was 20% below the real peak value of the S&P, from March 2000. But March 2000 was no ordinary peak but the height of the dot-com bubble. The market could still be grossly overvalued yet be 20% below that amount. And the market has continued to soar in the two months beyond Sept 2013; the S&P is up another 8%, so now it’s about 12% below its all-time bubblicious peak. Two lessons I draw: (1) stocks have been a lousy investment over the past 13.5 years, averaging about -1% per year in real terms, with a ton of volatility; (2) stocks could well be a bubble right now, but how large a bubble?

A still-better way to look at the stock market is the price-earnings (P/E) ratio. The measure here compares the current prices of the 500 stocks in the S&P index to their companies’ profits over the past 12 months. This chart is updated every trading day, but right now the P/E ratio is 19.87, compared with the historical averages of 14.5 (median) and 15.5 (mean). The all-time high was 123.8 in May 2009, and the all-time low was 5.3 during WWI. One could compare the current P/E of 19.87 to the historical averages and conclude that the market is about 28% overpriced (19.87 / 15.5 = 128%).

But we’re still not done. The appropriate P/E is not the same at all times. When interest rates on corporate bonds (the leading alternative to stocks) are very low and expected to stay that way for a long while, the P/E should be higher. Right now the interest rate on A-rated 20-year corporate bonds is 4.71%. An economist-approved way to compare stocks and bonds is to compare the P/E on stocks to 1/i, or 1 divided by the long-term interest rate. If investors were indifferent between bonds and stocks and cared only about their expected return, P/E and 1/i should be equal. (The 1/e ratio gives you the present-day value of a fixed-income investment that pays you $1 per year forever when the interest rate is i forever.) Right now, 1/i = 1/.0471 = 21.23, which would suggest that stocks are a bit under-priced relative to bonds. Except (if you can stand yet another about-face) there is no good reason why investors should be indifferent between bonds and stocks. Most people are risk-averse and would therefore prefer a guaranteed real return of, say 2% on bonds than an expected 2% return on stocks that could wildly fluctuate. So with normal, risk-averse investors, P/E should be somewhat less than 1/i. And with interest rates expected to rise someday, even if not any day soon, we should probably plug in a somewhat larger value of i than 4.71%. If we plug in 5% instead, then 1/i = 1/.05 = 20, just a tad higher than the current P/E of 19.87, which now looks too high. Not necessarily scary-bubble high, but overvalued just the same.

So when you think the market is a little overvalued but not necessarily a lot, should you dump your stocks? I guess that I just don’t know.

Fed talk is anything but cheap

After last Wednesday, I bet Ben Bernanke can relate to this observation by George Carlin about his Catholic upbringing:

If you woke up in the morning and said, “I’m going down to 42nd street and commit a mortal sin!” Save your car fare; you did it, man!

It’s the thought that counts! The Fed didn’t “do” anything last Tuesday and Wednesday at its Federal Open Market Committee meeting. Bernanke’s concluding comments about the continuing slump were not much more specific than “This too shall pass, someday,” combined with the obvious point that normal times will bring normal monetary policies. The main news was that he thought normal times would come sooner than many people expected. But that was enough. Evidently, the bond market was expecting the economy to be flat on its back for most of the next decade: 10-year Treasury bond rates had lately been in the range of 2.1-2.2%, whereas the recent historical norm is about 5%. After Bernanke’s remarks, the rate jumped by 30 basis points (0.30% point) to a Friday close of about 2.5%. It jumped further this morning to 2.6%.

Two observations:

(1) Just as in Carlin’s church, Bernanke doesn’t actually have to do anything to tank the long-term bond market. Just thinking about it aloud is enough.

(2) The long-term bond market is really not the economy’s friend. What tanked the bond market is the prospect of interest rates rising a bit sooner and faster than expected, on account of the Fed reacting to a stronger economy. So in a weird sense the spike in bond rates is good news: Bernanke said better times were coming, the markets believed him, and they acted accordingly. Not to say that their action was malicious, just that it was predictable: if you are expecting interest rates to rise in the future, you should buy bonds in the future, not now.

WTF, S&P???

How did I miss this one? Bloomberg News, on Aug. 31, reported that Standard & Poor’s is still giving its highest rating, AAA, to subprime-mortgage-backed securities:

Standard & Poor’s is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the U.S. government….

More than 14,000 securitized bonds in the U.S. are rated AAA by S&P, backed by everything from houses and malls to auto- dealer loans and farm-equipment leases, according to data compiled by Bloomberg.

(Hat tip: Simon Johnson.)

Did S&P’s downgrade actually help the Treasury bond market?

Yes, I think it did. As of 2:53 pm, the yield on ten-year Treasuries has plunged 20 basis points to an ultra-low 2.36%, their lowest level of the year. It’s the stock markets that are a bloodbath today, with the S&P 500 and Nasdaq down about 6%. Prices for the safe havens of gold and Treasury bonds are both way up. Inasmuch as the S&P downgrade has upped the fear factor, it’s hurt stocks and helped T-bonds.

To qualify this: The S&P’s role here has likely been vastly overstated by the media. (Krugman has already lost his lunch over this one, so I don’t have to.) For starters, when U.S. markets opened this morning, the T-bond market didn’t show much of a reaction either way (down just 2 basis points in the late morning, i.e., basically unchanged) and the stock markets’ initial tumble was not out of line with what they’d been doing the past two weeks (the S&P 500 fell almost 11%), going into the weekend. The snowballing of money out of the stock market and into the T-bond market is something that happened later in the day, not a plausible initial reaction to the downgrade. But plausibly the downgrade added to the general climate of fear, which got a lot more heated by the afternoon, so  . . . it still seems that agent 6373 has accomplished her mission.

Many commentators have said that the unfolding crises in Italy, Spain, and the European Central Bank are both more dire and more unpredictable than the revelation that Washington is so dysfunctional that even a disgraced ratings agency thinks so. The weekend’s bigger announcement may have been that of ECB President Jean-Claude Trichet that the ECB would try to alleviate Italy’s and Spain’s debt crises by buying up huge chunks of their debt. Otherwise known as monetizing the debt, the modern-day equivalent of printing money to pay the bills.* The announcement seems to have helped Italy’s and Spain’s sovereign debt markets a bit, as interest rates on those bonds fell slightly, but it casts doubts on the ECB’s credibility as a tough-minded central bank that doesn’t go around picking up the tab for member countries’ large debts.

* You might ask: Doesn’t the Federal Reserve do the same thing when it buys U.S. Treasury bills, notes, and bonds as part of its open market operations and “quantitative easing”? Not quite, though it does count as monetizing the debt. The big difference is that the Fed, with a few distant exceptions like during the world wars, does not try to buy up U.S. government debt just to help out the government. (Will they still be so above the fray if and when hardly anybody wants to buy U.S. Treasuries? I’ll leave that one for my libertarian commenters.)

What more could the Fed do?

I don’t claim to have the answer to this question. Those who propose an answer other than “nothing” don’t get a lot of airtime, but Dean Baker, one of my favorite gadfly economists, is one of them. He writes today that it is wrong, wrong, wrong to say that the Fed has run out of ammunition. While it is true that the Fed has lowered its usual policy target, the federal funds rate, as far as it can go (0-0.25%) and blown through two unusual policy actions known as quantitative easing (QE), there are other options that every policy economist has heard about. (Whether they’re wise options or not is the real question.) I’ll turn it over to Baker:

‘The Fed could do another round of quantitative easing, although this is likely to have a limited impact. It could also target a long-term interest rate, for example putting a 1.0 percent interest rate target on 5-year Treasury bonds.’

QE3 might well happen, although as Baker notes the impact is likely to be limited, as was the case with QE2. Since QE2 did not seem to roil financial markets, my sense is that there will be a QE3, with a slight downward push on medium- and long-term interest rates. But given the low business and consumer borrowing with today’s low interest rates, I doubt that nudging them further down will make a noticeable difference.

Targeting a long-term interest rate implies a more aggressive form of QE, where the Fed buys and sells long-term bonds in such a way as to control the market for those bonds. This is more than it does in its open market operations for Treasury bills, which are about hitting a target for the fed funds rate (the interest rate on loans of reserves between banks), not controlling the T-bill rate. I’m instinctively a bit leery of handing that much control over the bond market to the Fed, and I suspect financial markets would like it even less.

‘Alternatively, the Fed could pursue a path that Bernanke himself had advocated for Japan when he was still a Princeton professor. It could target a higher rate of inflation, for example 4 percent. This would have the effect of reducing real interest rates. It would also lower the debt burden of homeowners, which could allow them to spend more money.’

I’m really skeptical of this one on two fronts.

1. I don’t think it’s all that easy for the Fed to raise the inflation rate when the economy is stagnant. (The exception — stagflation in the 1970s — was a case where people lost all confidence in the Fed, and it’s not an episode anyone wants to repeat.) All the textbook models I’ve seen of inflation have it coming from either higher aggregate demand (the horse to inflation’s cart, not the other way around, and precisely what’s lacking in this depression) or from an increase in the money supply. And increasing the money supply is not as simple as dropping cash from a helicopter. In the real world the money supply increases as part of a multi-step process: the Fed gives banks excess reserves, banks willingly loan out those excess reserves to willing borrowers, those borrowers spend them, the cash gets deposited into bank accounts, which are part of the money supply. Note the “willing” parts in there — banks have to be willing to loan out their excess reserves, instead of sitting on huge piles of them as they’re doing now, and households and firms have to be willing to borrow money, instead of holding back out of economic anxiety.
2. Doubling the Fed’s target rate of inflation (it’s now 2%, unofficially) would not only be a political non-starter, likely leading to Congressional hearings or legislation to change the Fed’s charter, but it seems to rely on massive money illusion, i.e., a public too stupid to know what the inflation rate is. Financial markets can make big mistakes, but ignoring the inflation rate is generally not one of them. As Irving Fisher noted a century ago, if the expected inflation rate jumps from 2% to 4%, then nominal interest rates will also jump by 2 percentage points, leaving expected real interest rates (the ones that matter) unchanged. It is true that real interest rates on old loans and the real burden of old debt would fall, which would be good for debtors and ought to provide a net stimulus to the economy. But creditors would regard a planned inflation hike to 4% as theft, which could not be good for confidence overall and might inhibit future lending. Raising the inflation target to the historic norm of 3% would be better, but then we’re back to the question in (1): How?

I’m still looking for alternative stimuli the Fed could try, including different forms that QE3 could take. If you’ve got any ideas, the comments section is happy to have ’em.

Is inflation on target? (corrected)

The new BLS unemployment numbers (9.1% unemployment rate, 16.1% comprehensive unemployment rate, 117,000 new jobs created) are the talk of the morning. I don’t have much to add to it, but I’ll echo the oft-made point that job growth needs to be twice as fast for the next several years for unemployment to fall to normal levels. I’ll also note that the numbers are a bit better than those of a year ago, but a bit worse than those of March, when unemployment was 8.8%. So although the numbers are better than expected, they’re still underwhelming and we still might be in a double-dip recession.

Instead I want to focus on the other big economic variable. Inflation has been so low over the past few years — in the range of 1-2% — that Ben Bernanke and others have seemed more worried about deflation than inflation. At the same time, some Fed critics have charged that the Fed’s actions to backstop dodgy financial asset markets and flood the banks with new reserves will lead to a massive inflation after the slump is over or a stagflation (stagnant economy with high inflation) even sooner. Some numbers to remember: Inflation has averaged 3% a year over the past century, and close to that over the past few decades. The Fed’s unofficial target for inflation is 2%. What do the markets expect for the years to come?

A good way to answer that question is to compare the well-reported interest rates on regular Treasury bonds with the interest rates on “TIPS” — Treasury Inflation-Protected Securities. The payments on a TIPS bond are adjusted for whatever inflation occurs over the bond’s lifespan.  The inflation adjustment is trickier than I’d originally thought — instead of simply adding the inflation rate to the interest rate that arose from the bond’s auction, the interest rate stays the same but the bond’s principal rises, and the interest payments are based on the original interest rate times the new principal. (Ex.: Imagine a 1-year, $1000-face-value TIPS bond that sells at par, i.e., for $1000 and therefore has an interest rate of 0%. If inflation is 3% over the next year, then the principal rises 3% to $1030. The interest is still $0, but the overall yield on the bond is 3% ($30/$1000). That’s a simplified example. It’s more complicated if the interest rate isn’t 0%.) Because the arithmetic can get complicated, it’s easier to look up the “breakeven” rate, which is the inflation rate implied by the different on TIPS and ordinary T-bonds.

(Add to that a conceptual complication: Because the TIPS bond is less risky, since it’s indexed for inflation, it should be in somewhat greater demand than the regular T-bond. So, other things equal, it should command a higher price and pay a lower interest rate. With that in mind, the difference between the interest rates on regular T-bonds and TIPS bonds is roughly the expected inflation rate plus an inflation-risk premium, which reflects people’s uncertainty about future inflation.)

Comparing the interest rates for 5-year bonds last week (when this was originally posted), the  T-bonds paid 1.12% and the TIPS paid -0.67%. The implied inflation rate (1.80%, if my spreadsheet math is correct) is actually very close to the difference in the interest rates on the two bonds (1.79%). Apparently the market is expecting the Fed to be just shy of its 2% target over the next 5 years.

Looking at the 10-year bonds, the T-bonds paid 2.47% and the TIPS paid 0.24%. The 2.03-percentage-point difference is again a close approximation of the breakeven rate; my spreadsheet math yields an expected inflation rate of 2.22%, or slightly over the Fed’s target. Together the two breakeven rates imply that the market is expecting inflation to average about 2.6% in years 6 through 10. These numbers provide no guide to where they think that inflation is going to come from (recovery? shortages of gas or food? QE5?), but the weakness in the stock market suggests they’re not expecting a recovery anytime soon. It may just be that their flight to safety has gone into overdrive, and TIPS are in exceptionally heavy demand because they are even less risky than regular T-bonds. So possibly they’re expecting inflation rates of about 1% through 2016 and 2% in 2016-2021, with the remainder being a risk premium.

In sum, the Fed does seem to be hitting its inflation target, more or less, but that’s about all. Bondholders appear willing to lock in near-zero or negative real returns over the next five or ten years, just so they can hold a safe asset. Which suggests they’re scared shitless.