Last week Bloomberg featured an article about Finnish economist Katja Taipalus and her model for detecting asset market bubbles which she explains in her paper, “Detecting asset price bubbles with time-series methods.” Boiling down the 217 page paper to its essentials, she is trying to determine when stock market and housing prices diverge from their “fundamental” value.
Along with most mainstream economists she errs in thinking that assets have an objective value determined by the net present value (NPV) of future income. However, as Austrian economists know there is no objective NPV. Earnings forecasts and the discount rate used to calculate NPV are subjective. Future earnings will vary depending on the optimism of the forecaster. The discount rate changes according to each forecaster’s tolerance for risk.
Taipalus’ model uses the log of the yield of a stock market index to identify bubbles. If the yield falls at a rate set by her test statistics, then the model signals a bubble alarm. Tests of the model show that collapses in asset prices follow within a year of the alarm and recessions follow the collapse.
Experienced investors know that dividend yield is the inverse of the price-earnings (PE) ratio if all profits were distributed as dividends. Yield is E/P whereas price-earnings is P/E. So yield can fall if prices rise faster than earnings and yield will rise if prices rise slower than earnings. Economists love dividend yields for some reason while most investors tend to follow PE, but they tell us essentially the same story.