Is Too Much No Longer Wonderful?

Mae West is supposed to have said that “too much of a good thing can be wonderful.” Her expertise was apparently somewhat removed from the worlds of finance and economics. In our world, too much of a good thing implies market mania, bubbles, and irrational exuberance. With the boom and bust of the dot-com and housing cycles either fresh in our minds or apparent in any market chart you care to look at, even a taste of something good raises the specter of excess.

Fear of excess isn’t irrational. After all, the U.S. economy has been growing (almost) steadily for over five years, which means that the current business cycle has already outlived the average post-World War II economic expansion. With only one double-digit reversal along the way, the U.S. stock market has been appreciating for even longer. The S&P 500 Index has nearly tripled since its early 2009 low. Are we approaching too much of a good thing with results that are far from wonderful?

I think not, and here’s why. Business cycles and bull markets don’t end because too many days have passed without bad news or a market decline, but because important drivers of economic growth or financial market value have reached points of excess—too much capital investment, too much housing, too many employees, too much distance between asset prices and their intrinsic value. At points of excess, businesses retrench, workers lose their jobs, investment declines, and the economy turns down—a pattern that won’t be good for asset markets.

Are there systemic excesses today? Not that I can find. Net business investment, a frequent symptom of over optimism, remains well below to late ‘90s and mid-‘00s bubble periods (Chart I).

Businesses Still Cautious

Source: Bureau of Economic Analysis, 12/31/13.

Between 2002 and 2007, nearly 7 million single family homes were under construction; over the next five years, the total was 3.3 million.1 The U.S. needs an estimated 1.6 million new housing units a year to keep up with demand; we’re currently on track to build fewer than 1 million.2 Has the Fed created a bubble in the stock market? A bubble looks like 1999 did, when the S&P 500 Index price/earnings ratio was nearly 30 and my son’s buddy wanted to drop out of high school to trade internet stocks. Today’s 17.5 p/e ratio is just above the 60-year average of 16.64, and business news talking heads (though not this one) are telling us to worry (Chart 2). Markets climb a wall of worry.

Equity Valuations Well Below Peaks

Source: Bloomberg, 7/31/14. Index definition can be found at the bottom of this blog. Price/Earnings Ratio is a measure of the price of an index divided by the trailing 12-month earnings of the index. Past performance does not guarantee future results.sup>

Sometime this decade, businesses will most likely hire too many workers, add too much new equipment, lay on too much inventory. They will need to retrench with layoffs, idled plants, and heavy discounting. The stock market probably will have already begun to discount the resulting downturn in earnings and will have slumped itself. Sometime this decade, I suppose, but not yet.

  1. United States Census Bureau, http://www.census.gov/construction/nrc/historical_data/ 6/30/2014
  2. Haver Analytics, 6/30/14.

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Index definition:

The S&P 500 Index is a market capitalization weighted index designed to measure the performance of 500 large capitalization stocks in the United States. Index is unmanaged and cannot be purchased directly by investors. Index is shown for illustrative purposes only and is not meant to predict or depict the performance of any investment. Past performance does not guarantee future results.

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