In 2000, Yale economic professor and Nobel Laureate Robert J. Shiller published a book entitled "Irrational Exuberance" in which he explained that, contrary to a widely-held belief, markets are not necessarily rational. At times, they behave rather foolishly. We have reached one of those times. Wall Street has created a bubble. The question is no longer will it burst, but when.
Evidence of a bubble
In any business school around the world, in Finance 101, students learn that the value of a corporation is defined by its future incomes - the greater its expected incomes, the higher its value. This makes perfect sense, and explains why some corporations do much better than others. Google, Amazon, Facebook, Apple and Microsoft which have high expected profits, do much better than most others, pulling up the whole market. Yet, the stock market as a whole cannot do better than the whole economy. If the value of a corporation is defined by its expected profits, it follows that the value of the stock market is defined by the expected profit the economy will generate as a whole. Of course, one cannot predict what the expected profit of the entire economy might be. But, if one wants to have an idea of where the market is going, one may look at the relationship between corporate profits, as provided by the Bureau of Economic Analysis, and stock values, as given by indexes such as the Dow Jones or the S&P500. If one chooses the latter and plugs it on a graph along with corporate profits to see how the two evolve over time, one gets a pretty good idea of where the stock market is going. The result is hair raising!
Graph 1
Graph 2
As one sees on graph 1, both corporate profits and stock values moved along the same lines for nearly forty years. Beginning in the 1990s, the stock market began to rise at a higher clip than corporate profits. From 2009 forward, the stock market shot up, breaking away from corporate profits. The two are no longer united. Another measure confirms the overvaluation of the stock market. Investors use the price/earnings ratio, or P/E ratio, to assess its value. It is calculated by dividing a corporation's share price by its net income per share. Using this yardstick, a 2020 share is worth on average 31 times its net income. That's nearly twice its value in 1929 - the year the Great Depression hit the United States, and the rest of the world (graph 2). In May 2021, the ratio rose even further to 44, blowing off the chart. This should give pause to Wall Street and the Federal Reserve.
Graph 3
Graph 4
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