FOOL ON THE HILL
Bubbles or Stock Inflation?

Stock prices, just like the prices of other goods and services, rise too quickly sometimes, diminishing the value of a dollar. We understand the forces of inflation in the economy as a whole, so why isn't the concept of inflation also applied to stock markets as a warning to investors that prices get bent out of shape by expectations and market forces?

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By Richard McCaffery (TMF Gibson)
July 5, 2001

I wonder why the concept of inflation, so widely understood as a force in the economy, isn't used to explain rapid rises in the stock market as well -- say, during times of so-called "market bubbles." Why call it a bubble, leaving everyone to wonder what that means, rather than just calling it inflation?

Isn't a rapid rise in stock prices -- beyond levels reasonable investors, economists, and analysts consider rational -- simply market-specific inflation, a kind of localized price increase? We see it in commodities markets all the time. Have you seen the price of gasoline lately? It seems fairly clear that rapidly rising stock prices have a great deal in common with inflation. (I'm very much open to feedback on this idea, by the way. Maybe I'm just missing something obvious.)

  • In a sense, they both are the result of too much money chasing too few goods. When every investor wants to own Cisco (Nasdaq: CSCO) or a flashy group of biotechnology stocks, prices for these scarce resources will rise -- at times far beyond their intrinsic value, whatever that elusive number may be.

  • Liquidity is a marvelous thing. It encourages spending, commerce, and growth. It also encourages speculation. This isn't a bad thing. It's good that some folks speculate, since it adds completeness to the market. If nobody was willing to accept additional risk to make a profit, investors looking to hedge an existing risk wouldn't have anyone to trade with. Speculation, of course, can be carried to extremes, and when investors as a whole are pouring money into stocks at highly speculative prices, the system gets inflated.

  • When inflation distorts the information conveyed by prices, people make bad decisions. Just as consumers tend to pour time and money into inflation-beating schemes rather than more productive avenues during periods of rapidly rising prices, investors end up burning up lots of cash buying and swapping overpriced stocks rather than spending money in ways that create real value. Isn't that inflationary behavior?

I wonder if some economists are just too wedded to the concept of efficient market theory to recognize that even prices in efficient markets get bent out of shape by inflationary or recessionary forces. It's not clear to me why the economic way of thinking, which provides such flexible tools for understanding the way economies and individual investors behave, doesn't have the same flexibility for understanding the way stock markets behave.

I'm not suggesting chucking out the efficient market theory. It explains a lot of what we know about the stock market: It isn't easy to beat an index fund. Opportunities to make a quick buck aren't abundant. But even if stock prices do adjust quickly to reflect economic value -- which is what efficient market theory says -- basic economics says value is subjective. Doesn't it follow from this axiom that prices will get wacky sometimes; say, when the economy is humming along, people start thinking the Internet will make them rich, and demand for stocks skyrockets? 

Anyway, you might be wondering: If this is true, what's the big deal? Say we call the next stock market bubble an inflationary episode. What's in a name change? For one thing, it would be useful for investors to understand that stocks, like any other product or service, can be mispriced -- not all the time, and not always wildly -- but mispriced just the same.

It would be useful for investors to understand that when stocks, just like other assets, products, and services, are rising quickly in price, the purchasing value of the dollar is being diminished, and therefore investors may not be getting much value for the price they're paying. There's a big difference between paying 15 and 50 times earnings for a company's stock, just as there's a big difference between paying $1.50 and $5 for a hamburger. 

It would also give investors a better understanding of the opportunities available when the pendulum swings the other way and the market slumps -- and a built in bias, perhaps, to think about spending or investing when no one else wants to. This is what Berkshire Hathaway (NYSE: BRK.A) Chairman Warren Buffett was talking about when he said the secret to investing is to be fearful when others are greedy and greedy when others are fearful.

Rather than debating the efficiency of the stock market, or cutely describing the rapid rise of stock prices seen in the late 1990s as a stock bubble, you might do better to simply recognize that inflation plays a role in the stock market as well as the broader economy, and you must be careful. You don't always get what you think you're paying for.

Richard McCaffery doesn't own shares in any company mentioned in this report. The Motley Fool is investors writing for investors.