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It’s not just stocks; everything is overvalued

Published: May 10, 2013 7:00 a.m. ET


Commentary: Bull markets can persist a long time, but not forever



WASHINGTON (MarketWatch) — Stock markets are hitting new highs almost every day, leading to some tense debates about how much higher stock values can go.

Of course, anyone who’s been watching the markets over the past 15 years knows that stock markets can get extremely overvalued and stay that way for a long time. And they can get undervalued, too.

Profits are very high, but so are stock prices. The price/earnings ratio is at levels previously seen only right before a crash.

In the short run, equities are worth what people will pay for them, and that depends as much on psychology as it does on fundamental economic values. In the short run, investors can rely on expected capital gains to justify almost any price; all you need to do is find someone willing to pay more than you did.

But over longer periods, stocks can’t be worth much more than can be justified by their underlying economic returns.

Unfortunately for market timers, the long run can be very long way away. Like 20 or 30 years.

The fundamental bullish argument for equities goes something like this: All the stars are aligned for a bull market. Interest rates are very low and are likely to stay low for a while, which means corporations’ cost of capital is low. The economic recovery is bound to strengthen, which means sales and profits should rise.

The psychological case is also bullish. Investors are desperate for higher returns than they can get from safe, boring bonds that pay almost nothing. For most investors, that means buying equities.

Recently, researchers at the New York Fed concluded that equities will likely produce high returns for the next five years, in large part because bond yields are so low.

There are lots of bulls out there, telling the same story: Don’t fight the Fed. If Ben Bernanke and Mario Draghi are willing to keep pumping billions into the market, you’d be a fool to go against them.

How much is market really worth?

Major indexes are striking nearly daily record highs. But with earnings growth slowing sharply, are stocks overvalued?

The bullish case is a strong one. But it doesn’t mean that equities aren’t overvalued, perhaps massively so. The same may be true for all asset classes, argues David Levy, chairman of the Jerome Levy Forecasting Center.

“From surging bank stock prices to rising Manhattan coop values, all present bull markets are zero-interest-rate bull markets,” Levy wrote recently. These bull markets are occurring in an environment of high private-sector debts and limited growth potential, and therefore are “intrinsically speculative, limited in their potential, fragile and ultimately capable of severe declines.”

Levy is an unusual economist, because his model of the economy explicitly includes financial flows, unlike mainstream models that focus more on production and consumption but essentially ignore finance, profits, assets and debt. His model owes a lot to his grandfather, Jerome Levy, as well as to Hyman Minsky and Michal Kalecki. Good company.

Levy’s approach focuses the mind on the imbalances that can grow almost imperceptibly until, suddenly, they’re destroying the economy.

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