theNiteOwl - "and to keep us on our toes"
and this is a scary one
cepr.net
center for Policy and Economic Research.
Double Bubble: The Implications of the Over-Valuation of the Stock Market and the Dollar
by Dean Baker
Executive Summary
The stock market is over-valued by close to 50 percent, according to most economists who have examined stock prices and trends in corporate profits. The dollar may be over-valued by 30 percent, or more, as evidenced by the large and growing United States current account deficit. These over-valuations present extraordinary misalignments, in which major markets are seriously out of line with their long-term values. These misalignments, and the inevitable adjustments, will have enormous consequences for the United States economy.
This paper examines the evidence that both the stock market and the dollar are significantly over-valued. It then examines the implications of the adjustment process whereby each moves towards a more sustainable level. The paper also examines some of the interactive effects of the adjustments occurring simultaneously-- which is quite probable, since investors are likely to flee the dollar and the stock market at the same time. Finally, the paper briefly discusses some policy prescriptions for dealing with the current situation.
The case for the over-valuation of the stock market is very straightforward. The ratio of stock prices to corporate earnings is close to twice its historic average. This extraordinary price to earnings ratio is occurring at a time when the profit share of GDP is already at a post-war high-- which means that it is likely that profits will grow less rapidly than GDP in the future. The projections from the Congressional Budget Office show profits falling by a total of 4.0 percent over the next ten years, after adjusting for inflation. Unless the price to earnings ratio rises ever higher (an unrealistic prospect), stocks will not even be able to match the return from government bonds, given the current price to earnings ratio.
The only way that stocks can again provide returns that include a significant risk premium over government bonds is if they first fall by close to fifty percent in price. At a lower price to earnings ratio, stocks will have a higher dividend yield. Currently the dividend yield (including money paid out as share buybacks) is close to 2.0 percent. If stock prices fell by fifty percent, the dividend yield would rise to 4.0 percent, which is approximately the historic average. This would allow the total return on stocks (dividends plus capital gains) to be more in line with the historic average.
It is important to note that there is no plausible growth path for profits under which current stock valuations would make sense. Even if profits grew far more rapidly than CBO projects, stocks would still be providing returns which would be far below their historic average, and not much above the returns available on government bonds.
The over-valuation of the dollar can be determined based on the large current account deficit that the United States is presently running. If the trade deficit stays at the level reached in the first quarter of 2000, the current account deficit for the year will be over $460 billion, or 4.8 percent of GDP. Trade deficits of this magnitude are not sustainable. If the trade deficit were to remain constant as a share of GDP, by 2010 the ratio of U.S. net foreign debt to GDP would be nearly 70 percent, and the annual current account deficit would be over 6.0 percent of GDP.
The paper shows that plausible differences in the future growth rates of the United States and its major trading partners are not likely to correct the trade and current account imbalances any time soon. Rather, it will be necessary to have a large fall in the value of the dollar, in order to raise U.S. exports close to balance with the volume of imports. Standard estimates of elasticity imply that the necessary fall in the value of the dollar would be between 20 and 30 percent measured against the currencies of major trading partners.
The decline in the stock market will have dramatic demand and supply-side effects. On the demand side, a decline in stock prices would mean a loss of wealth of approximately $9 trillion, or more than $30,000 for every person in the country. Using standard estimates of the size of the wealth effect, this implies a reduction in annual consumption of between $270-360 billion a year. In addition, a collapse of stock prices is likely to significantly reduce investment by high-tech firms that were relying on the stock market for financing. With this sort of fall-off in demand, it will be very difficult to avert a severe recession.
Collapsing stock prices will also have a direct effect on the federal budget. CBO projections assume more than $900 billion in taxes on capital gains over the next decade. This could fall close to zero with a serious correction in the stock market. The loss of capital gains tax revenue, combined with the impact of an economic downturn, could lead to large budget deficits. Under these circumstances, if Congress insists on running a balanced budget by raising taxes and/or cutting spending, it will lead to an even larger falloff in demand.
On the supply-side, stock options have increasingly been used as part of workers' pay packages, particularly in the high-tech sector. If these options are seen as being worthless, it could lead to considerable disruptions in the labor market as workers seek to have options replaced with straight salary increases. Insofar as firms are forced to shift from options to wage and salary payments, it will reduce profits. This could amplify a downturn in the stock market.
The decline in the value of the dollar will have a significant inflationary impact on the economy. Standard estimates of the pass-through of exchange rate changes imply that the overall rate of inflation will increase by 1.4 to 2.1 percentage points as a result of the decline in the value of the dollar. This would mean that the current 3.0 percent rate of inflation would rise to between 4.4 and 5.1 percent, as a result of the impact of the falling dollar.
The interaction between the collapse of the two bubbles could make matters better or worse, depending on the policies pursued. If the Federal Reserve Board is prepared to tolerate the resulting inflation, the fall in the dollar could provide a very important source of stimulus, as net exports rise to offset the decline in consumption. On the other hand, if the Federal Reserve Board insists on fighting any increase in the rate of inflation, it would mean raising interest rates, even as the economy is sinking into a recession. Such a policy could support the dollar for a period of time, but it would only delay the necessary adjustment.
The most important policy conclusion from this analysis is that it has been irresponsible to allow these bubbles to grow to the extent they have grown. There are significant short-term gains from an over-valued stock market and dollar. The former creates an illusion of wealth; at the same time the resulting consumption and investment to some extent creates real prosperity. Similarly, an over-valued dollar allows people in the United States to buy goods and services around the world at a substantial discount compared with a situation where the dollar is properly valued. This increases the purchasing power of workers' paychecks.
But such bubbles are not sustainable, as this paper demonstrates. The long-term costs of the inevitable corrections are likely to dwarf the short-term benefits that have been derived from the bubbles. The Federal Reserve Board and the Clinton Administration should have acted long ago to try to deflate the twin bubbles. The nation will very likely pay a substantial price for this policy failure.
In the case of both bubbles, it would be desirable to have a quick adjustment process. This will stop the damage from getting worse. |
