Are we experiencing a stock market bubble?

The Dow Jones Industrial Average closed today (March 8th) at another record all-time high of 14,397.07. On the surface this seems like great news.  At long last we are emerging from the Great Recession of 2008.  I read an article in today’s Oregonian which stated that with the recent rise in home prices and the robust increases in the stock market that most Americans have regained the net worth they lost five years ago due to the collapse of the economy.  Wouldn’t that be good news if it were true?  It makes me want to sing a round of “Happy Days Are Here Again.”  

The question that is on my mind, and a lot of like minded people is, “Are we experiencing a stock market bubble caused by The Fed’s quantitative easing policy?  Federal Reserve Chairman Ben Bernanke says emphatically “no.”  He recently told the Senate Banking Committee that he "does not see much evidence of an equity bubble." Yes, stocks are high he says, but that’s because The Fed’s recent policies, which have kept interest rates near zero since 2008, are working to spur spending. 

So let’s begin with the facts.  I think there are three possible reasons for the stock market surge:

• First of all the economy is not as weak as we have been led to believe.  We have seen modest growth in autos, housing and manufacturing activity.  Today’s employment report shows improvement in the private sector employment resulting in a downward tick in unemployment to 7.7%.  Not great but improving, nonetheless. 
• With The Fed’s policy of keeping interest rates at near zero is making it impossible to get an honest return on bonds, savings accounts, money market funds or CDs.  I believe investors are putting their money in equities because these other traditional forms of investment have been taken away from them.
• There is some evidence to suggest that investor confidence is surging because we have avoided the serious crises in Europe and the United States from imploding.  The euro zone crisis and the fiscal cliff crisis in the U.S. have worked their way out and investors feel more confident that we will continue to somehow muddle through. 

However when you look at the stock market fundamentals there is little justification for the recent rise in equities:

• Profit growth has been slowing.  The growth rate in the S&P 500 has slowed from 6.0% last year and is projected to be 1.2% the first quarter of this year. 
• The best long-term measure of value is the price-earnings ratio.  Currently the PE ratio is at 22.9 which is 39% above its long term average.  In other words stocks are significantly over priced.  An old rule of thumb is when investors buy assets at above average valuations they will suffer below average future returns.

It is my opinion that this bull market is not driven primarily by economic reality on the ground but by The Fed’s quantitative easing policy.  Fed Chairman Bernanke says that he plans to continue this policy for at least another two years which bodes well for the stock market for the foreseeable future.  In the short run I wouldn’t bet against The Fed Chairman.  But at some point when a new crisis emerges or an old one raises its ugly head then all bets are off.  

Sources: The Great Stock Market Rally, The Huffington Post by Jerry Jasinowski, March 8, 2013; Better than the alternatives, The Economist, March 9, 2013, Bernanke: There is no stock bubble, CNNMoney by Annalyn Kurtz, February 26, 2013.