Popping Bubbles

Mainstream economists buried the business cycle in the last decade of the 20^th century. Having discovered that pronouncement of its death to be premature in 2008, they have suddenly rediscovered asset markets and cast them in the role of villain in the business cycle melodrama. They think that the popping of asset bubbles triggers recessions so they have been searching for ways to identify bubbles in fetus stage and abort them.

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.

Here is a graph of the Shiller PE ratio :

Now if rapidly falling yields signal an approaching bubble, and PE is the inverse of yield, we know that a rising PE ratio does the same thing. A rising PE ratio tells investors that prices are rising faster than profits and that means investors are taking greater risks for the same profits.

And we see that pattern throughout the business cycle. In the early years of a stock market recovery after a recession, PE ratios will be historically low and may fall as profits rise faster than stock prices. Investors are still wary and risk intolerant. PE ratios will quit falling as confidence picks up then begin to rise as investors turn more confident and are willing to take more risks. In the latter stages of a bull market, profit growth will stall and even decline before investor confidence does and that will cause PE ratios to climb.

Current PE is far below the rare air of the last two market tops, but by historical standards is still high. My guess is that investors won’t push PE much higher, having been seriously burned by the falls from the previous heights.