Are we in an asset bubble? Some people say we are. Think about it ... real estate, stocks, oil, gold, corn, emerging markets, junk bonds ... every asset you can think of has been in a sharp, upward trajectory for years, it seems. And it doesn't stop at asset prices. What about consumer spending? And debt? Both appear to be in an ever-upward spiral as well.
Is this normal? Is it healthy? Or are we to believe the doomsayers who insist that we are inflating a balloon that is one day going to bring horrific consequences when it bursts?
Good questions, no doubt, and we should be thinking about these things, because they could affect the outcome of our investments in a very big way.
Clues in the data
In looking for answers, I begin, as I always do, in the role of economic detective. I look for clues, patterns, or trends buried in long-term economic data series that might yield some information. Obviously, if I am investigating a potential asset bubble, I must start with an examination of assets to see whether they are being inflated. Has too much air been let into the balloon too quickly? That's what needs to be determined.
What I discovered was startling. For 50 years following the end of World War II, the ratio of assets to gross domestic product stayed pretty constant at around 3.8-to-1. That means the market value of all assets held by households in the U.S. -- stocks, real estate, bonds, cash, tangibles, and the like -- roughly equated to 3.8 times one year of GDP. So if the economy grew, so did the market value of assets held, roughly by the same ratio, over all those years.
Then, in the latter part of the 1990s, something started to happen. The market value of the assets held by households started to rise more quickly than the gains in GDP. That 3.8-to-1 ratio jumped to 4.8-to-1 in 1997, 4.95-to-1 in 1998 and 5.27-to-1 in 1999, where it peaked. From 2000 to 2002, it came down, hitting a low of 4.54, but it has been on the rise again and is back up around 5.0.
There are many likely explanations for this breakout from the postwar trend. The decline in inflation led to a decline in interest rates, and that made capital cheaper. This triggered an investment boom that raised asset prices. Technological advances in the 1990s and the rise of the Internet boosted productivity, and that greater productivity contributed to higher profits. Finally, globalization and the fall of communism helped open markets and liberate a generation of savings that had been sitting idle.
Negative savings rate or high investment rate?
Let's talk about that last point for a minute. When communism collapsed, what emerged was a vast ocean of private savings that citizens in those countries had, up until that moment, been squirreling away. They held on to their money (or exchanged them on the black market for dollars if they could) because there was little else for them to do with it.
In contrast, the U.S. is often criticized for its negative savings rate (which, as I have said before, is a mischaracterization). What is not mentioned is that Americans invest far more than anyone else does. We even borrow to invest, because the returns on capital in the U.S. exceed the cost of money. That's also the reason foreigners send their savings here.
Back to the analysis ...
I mentioned that the historical peak in the asset-to-GDP ratio occurred in 1999, when it hit 5.27-to-1. That clearly seemed tied to the bull market in stocks. In 2005, the ratio hit 5.14-to-1, which was probably attributable to the real estate boom. As it stands now, the 5.27 level is the high-water mark. Whenever the asset-to-GDP ratio climbs to that level, caution is probably advised.
But will it get back up there?
A dearth of assets
I will defer to the late Nobel laureate economist William Vickrey in answering that question:
"... the aspirations for asset holdings to finance longer retirements at higher living standards have increased sharply. At the same time, rising wealth has increased the number of those with a high propensity to save for other purposes, such as the acquisition of chips with which to play high-stakes financial games, the building of industrial empires, the acquisition of managerial or political clout, the establishment of a dynasty, or the endowment of a philanthropy. This has further contributed to a rising trend in the demand of individuals for assets, relative to GDP."
Vickrey meant that with the economy transforming -- from heavy industry to information technology and service -- there will be more savings than assets, and that situation will place upward pressure on asset prices.
To counterbalance this development, Vickrey said, the government must run deficits higher than what is normally desired because the government borrowing will supply the assets -- in the form of Treasury bonds, notes, bills, and such -- that will be necessary to absorb the surfeit of savings.
That's an ingenious idea, but it's not likely to be implemented in the current policy environment. With budget balancing on the mind of both the president and Congress, expect to see some acute asset overvaluations in the coming year or two before this run is over. What does that mean for the asset du jour -- stocks? Up, up and away!