Everyone’s Talking About Market Bubbles

After a brief lull, one of 2014’s dominant financial-markets themes is back: the big debate about whether we’re in a bubble.

With a difference. Now the chatter isn’t just about stocks and bonds in the U.S. It extends to just about every other type of asset around the world. A recent front-page article in the New York Times put it this way:

“Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.”

Well, no. Stock prices indeed are higher than their historical averages in some markets. So are prices of most of the world’s government bonds. But equities in the emerging markets are not near their highs. Neither are gold and single-family homes in much of the U.S. And “relative to the fundamentals” is a highly subjective opinion.

As has been well documented over the years, the likely primary explanation for current valuations of various assets, overvalued or not, is unprecedented central-bank monetary stimulus that has driven interest rates to or near record lows.

Both Federal Reserve chairwoman Janet Yellen and Mario Draghi, president of the European Central Bank, decided to air their views on the bubble/valuation subject this week.

The published report that the Fed released accompanying Yellen’s testimony before Congress said: “Valuation metrics in some sectors do appear substantially stretched — particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

But the report also commented that broad-market valuation measures are “generally at levels not far above their historical averages.” This suggests that investors “are not excessively optimistic regarding equities.”

Yellen also said: “While prices of real estate, equities and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms.”

Draghi said on Monday that he didn’t see a risk of widespread asset bubbles in the euro zone, even if some markets are “frothy.” He acknowledged that investors had driven up the prices of riskier assets, with reduced premiums over less risky assets. But he also said that demand for high-yield investments had not been accompanied by a surge in the kinds of debt that preceded the financial crisis. “We don’t have the general conditions that accompany the creation of systemic bubbles,” he added.

Some air came out of the pseudo-bubble yesterday. The Standard & Poor’s 500 slumped 1.2 percent, its biggest drop since April. First, a Malaysia Airlines plane was shot down over the Ukraine, killing 298 people. Then Israel launched an invasion of Gaza. Until yesterday, U.S. markets had not been affected much by geopolitical tensions this year.

Yesterday also was the first time that the S&P 500 moved by more than 1 percent since April 16, the longest such streak since 1995. And the CBOE’s Volatility Index, the VIX, surged 32 percent to 14.54, its biggest one-day gain since April 2013. This so-called fear gauge recently hit a seven-year low.

Prices of U.S. Treasury bonds, widely viewed as overpriced, rose in an investor flight to safety as yields on the benchmark 10-year issue fell below 2.5 percent.

This is all the more amazing considering that Yellen this week also said that the Fed likely would start to raise its short-term interest rate, now at zero-0.25%, earlier than currently expected if the labor market continues to improve more quickly than now anticipated.

In sharp contrast, interest rates rose sharply in June 2013 when then-Fed chairman Ben Bernanke first hinted that the Fed would start to taper its bond-buying program at some point. That taper finally began in January and is expected to be completed in October.

Still, Yellen noted low levels of labor-force participation and slow wage growth as evidence of “significant slack” in the job market. She said the Fed previously has been misled during the economic recovery by “false dawns.” She added: “We need to be careful to make sure the economy is on a solid trajectory before we consider raising interest rates.”

The current expectation is that the Fed will start raising short-term rates around the middle of 2015, with the benchmark rate climbing to 1 percent by the end of next year.