Not Fully Inflated

Many investments are becoming expensive. But there is little sign of the mania that accompanies most bubbles.

Dimitri Vayanos and Paul Woolley of the London School of Economics have suggested that problems of agency contribute to bubbles. Investors do not buy shares directly but hire fund managers to do it on their behalf. They tend to select managers who have performed well in prior years. As the managers receive cash from new clients, they buy their favorite stocks which, by definition, will have performed well — witness the enormous sums flowing into tech funds in the late 1990s. The favored stocks get driven even higher.

Property bubbles also have a self-reinforcing element. Most properties are bought with money borrowed from banks. When prices are rising, banks are more confident about lending money; the greater availability of credit means that borrowers can afford higher prices, and so on. Conversely, of course, when banks become unwilling to lend more money, prices can collapse.

Many commentators believe current monetary policy may be encouraging bubbles to form. Nominal interest rates in much of the developed world are close to zero, and central banks have been buying bonds through the policy of quantitative easing. The intention is to reduce yields on the safest assets and so encourage investors to buy riskier ones, reducing financing costs for companies and boosting economic confidence through the wealth effect.

Low interest rates may also persuade some investors that risky assets are worth more. If one lowers the rate at which future cash flows are discounted, then the present value of an asset rises. But that is only if other things stay equal. Central banks have adopted their current monetary policy because they worry that the outlook for economic growth has deteriorated; if they are right, then investors should be reducing their estimates for the cash flows they will receive from dividends, rents, etc.

That may leave markets exposed to two risks: that the income from assets does not rise as quickly as investors hope and that capital values decline sharply if monetary policy changes. In its latest report on financial stability, the Bank of England acknowledges that monetary policy has had spillover effects. “Large capital flows into emerging economies have enabled credit levels in these countries to rise sharply,” it states. Emerging markets wobbled this summer when the Federal Reserve spoke of scaling back its monetary stimulus.

Looking back over five years, it is worth reflecting that markets have rebounded from some huge falls in 2008 and early 2009. Investors’ returns over the last 15 years have not been great. But there are a number of markets that look overvalued on an historical basis. American equities are trading at a cyclically-adjusted price-earnings ratio of 25, according to Mr. Shiller. This is much higher than the historic average of 16.5 but below the levels reached in the great peaks of 1929 and 2000. Corporate profits are also at their highest level relative to GDP since the second world war, suggesting further growth is unlikely.


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