Are we in an invisible stock bubble?

Marketplace Staff May 24, 2011

Are we in an invisible stock bubble?

Marketplace Staff May 24, 2011

Kai Ryssdal: As a whole, American banks are doing all right. Pretty well, actually. So said the FDIC this morning. Outgoing chairwoman Sheila Bair announced banking’s collective quarterly earnings were up 66 percent the first three months of the year.

There are some caveats, as there usually are. Profits were concentrated in the very biggest of the big institutions. And banks are still failing at a higher rate than one would like. But for now at least, corporate profits — like the ones the banks are enjoying — are helping to keep the stock market higher than it might deserve to be.

Bubble is a strong word, I know, but Jack Hough writes in SmartMoney magazine that maybe we’re looking at the wrong indicators as we judge where the market ought to be. Good to have you with us.

Jack Hough: Nice to be here.

Ryssdal: We have this thing we look at when we talk about stock prices, it’s called price-to-earnings ratio: the stock price as compared to a year’s worth of a given company’s earnings. You suggest in this piece in Smart Money that maybe P/E ratios, as they’re known, aren’t really the right measure. So what should we be looking at?

Hough: They might mislead right now. Stock investors know what a P/E ratio is; if you’re not a stock investor, you’re not familiar with them, don’t worry. Just know that historically, the average stock in America has traded at about 15 times earnings, maybe just a touch less than that. And right now, the stock market as a whole is about 15 times earnings. So on the surface, it seems like there’s not much to worry about with stock prices. But in my piece, I basically wrote about you have to look at earnings — corporate earnings — as a share of the economy. What you find right now is that corporations are so far into record territory with the size of their earnings relative to the size of the economy that, in the past, that has signaled a decline in earnings waiting to happen. And that could bring stock prices down.

Ryssdal: Is it some function of corporations making so much more money than they have in the past, and workers — that is to say, wages — not being as big a chunk as they have in the past? Because as we know, wages have been stuck.

Hough: That’s exactly what it is. When you look at the trend of the past decade, companies making a lot more money overseas, that’s great for their profits, but what’s happening to America’s workers? You know, we’ve lost jobs and the new jobs that we’re finding don’t have such great wages. So keep in mind that workers are also shoppers. Corporations need workers to make decent money so they can continue to buy their products in the U.S. And I think that’s why there’s been this relatively constant relationship, you know, corporations are always struggling with workers for who gets a bigger slice of the economic pie, but when one wins out too well, that’s usually temporary.

Ryssdal: Give me a sense of how out of whack, versus the historical mean, corporate earnings are as a share of the economy.

Hough: Well the historical average is 6.4 percent. And we had some high periods in the past that were in the 8 percent to 9 percent range.

Ryssdal: That is as a percent of national income, right?

Hough: Exactly. And those periods were always followed by a short decline in earnings. Right now, we’re between 9 and 10 percent. There’s only two points in history when we were this high before: one is 2006, that’s just at the peak of the housing bubble, just before the recent financial crisis; the other was in 1929, just before the stock crash that kicked off the Great Depression.

Ryssdal: So is there a chance — we’ve all talked about how the economy has changed and we have conceivably a new normal — could it be that corporate profits are just going to be this high, and we’re going to have to get used to this?

Hough: You know, one explanation is, as I said, companies are making more money overseas, so if we believe that emerging markets are going to boom forever, maybe we’ll be OK. But I’m always suspicious of arguments like that that say the rules have changed. I think a more likely scenario is that earnings are going to come down and if they do, I think as a stock investor, you just want to be a little cautious right now. It’s not like you want to dump everything and run for the hills, but you want to start thinking safe, start maybe raising a little cash, start buying safer stocks than you otherwise would.

Ryssdal: Jack Hough, columnist for SmartMoney magazine. Jack, thanks a lot.

Hough: Thank you.

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