Is the stock market a bubble? By the simplest textbook rule of thumb, the US equity market is tracking the discounted value of corporate earnings. The price of a stock should be equal to the expected future earnings stream discounted by the prevailing interest rate, that is, PRICE = EARNINGS/DISCOUNT RATE. What expected earnings might be, and which discount rate we should use, are matters of learned conjecture. All we can observe is the price of stocks, and present earnings (if we believe the accountants).
Nonetheless, a crude comparison is interesting. The accompanying chart shows the S&P 500 Index price against “discounted earnings,” that is, pre-tax corporate profits as reported in the GDP tables divided by the 30-year Baa corporate bond yield. That’s not quite right; S&P profits don’t correspond precisely to the GDP measure of corporate profits, and the Baa yield incorporates a big component of risk (the academic model uses a default-free rate like Treasury bonds). Nonetheless, it’s indicative.
During the great dot.com bubble of the 1990s, the S&P rose far more quickly than the discounted value of profits, as investors poured money into start-ups in proportion to their burn rates. The markets followed a mirage of future earnings from untested businesses and, of course, crashed.
Today stock prices follow this (admittedly somewhat arbitrary) measure of discounted earnings. Corporate bond yields are low, to be sure, because the overall rate structure is low, and because corporate America has a much stronger balance sheet and steadier cash flows than it did ten years ago. But that should be good for stock prices. US stock prices undoubtedly are rich (a forward price/earnings ratio of 20 vs. around 30 before the 2000 stock crash), but rich is not the same thing as crazy.