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Financial Bubbles: What They Are and What Should Be Done

Financial Bubbles: What They Are and What Should Be Done CEPR Basic Economics Seminar Dean Baker November 10, 2005. Financial Bubbles: What They Are and What Should Be Done. The Nineties Stock Bubble: The Secrets of Simple Arithmetic

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Financial Bubbles: What They Are and What Should Be Done

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  1. Financial Bubbles: What They Are and What Should Be DoneCEPR Basic Economics Seminar Dean BakerNovember 10, 2005

  2. Financial Bubbles: What They Are and What Should Be Done • The Nineties Stock Bubble: The Secrets of Simple Arithmetic • The Housing Bubble: You can always live in an overpriced house • Bubbles Aren’t Cute: How bubbles harm the economy • How the Fed Can Burst Bubbles • Holding the “Experts” Accountable

  3. The Simple Arithmetic of the Stock Bubble • Short-term (1 day to 5 year) stock returns are unpredictable, largely random • Long-term stock returns can be predicted based on profit growth and PE ratios • Forecasters (CBO, OMB, private forecasters) routinely make profit growth projections, therefore it is very simple to derive stock return projections • Stock returns have two components: capital gains (the rise in share price) and dividend payouts (including share buybacks) • Stock returns = capital gains + dividend payouts – DEFINITIONAL TRUTH

  4. Projecting Stock Returns • Assume PE is constant through time – then capital gains equal the rate of growth in profit • Dividend payouts average 60% of profits – limited by the need for reinvestment • Dividend yields – 60% of earnings yield (inverse of PE ratio) • Therefore, stock returns = profit growth + 60% of earnings yield

  5. Stock Returns: Normal and Bubble Years • Normal • Profit growth 3.0% a year, capital gains 3.0% a year • Historic PE 14.5 to 1, implied earnings yield 7.0 percent • Dividend yield = 60% of 7.0% = 4.2% • Stock return = 3.0% capital gains + 4.2% dividend yield = 7.2%

  6. Stock Returns: Normal and Bubble Years • Normal (7.2%) • Nineties Bubble Years • PE crossed 20 in 1996 and 30 in 1999, so earnings yield was under 5% after 1996 and close to 3.0% in 1999 • The dividend yield fell from 3.0% in 1996 (60% of 5%) to less than 2% in 1999 • Normal profit growth was 3.0% but 1996-2000 were near cyclical peaks. CBO projected NEGATIVE real profit growth from 1999 to 2019 • In bubble years, projected stock returns would have been 2.0-3.0 percent from dividends, plus minimal capital gains, depending on growth assumptions • Investors would receive much better returns from government bonds

  7. Projections If the Price to Earnings Ratio Isn’t Constant If the PE ratio rises, then dividend yield falls, leading to ever higher PE • If the PE falls, then capital gains are negative and returns are far worse than if PE stays constant • A high PE guarantees low returns unless profit growth goes through the roof

  8. How to Recognize a Housing Bubble • In the long run, house prices nationally have followed inflation • In the long run, house prices have risen more or less with rents (same market) • Unless some fundamental factor has changed, then the run-up since 1997 is a bubble

  9. The Realtor’s Fundamentals • Population growth – it’s slower today than in prior decades • Rising incomes – incomes grew far more rapidly in the 50’s and 60’s • Environmental restrictions on building – the late 90’s were not the heyday of environmentalism (Republican takeover of Congress and state houses) • Limited supply of land – land has always been limited; what happened to Internet removing restrictions of time and space? • Low interest rates – if low interest rates explain the run-up, then house prices will plummet when interest rates return to normal • It is interesting to note that the fundamentals just started to drive up house prices at the same time the stock bubble was pushing up stock prices. (Stock wealth can lead to higher real estate prices, just as in Japan in the 80s)

  10. Bubbles: National and Local • Housing markets are local, but there are common factors • The collapse of the bubble will not hit every market equally (the collapse of the stock bubble didn’t hit every stock equally) but virtually all markets are likely to see price declines • Higher interest rates will likely lead to a collapse, but overbuilding will eventually saturate the market, even without an increase in interest rates

  11. Bubbles and the Economy Why They Aren’t Cute

  12. How the Stock Bubble Harmed the Economy • Misdirected investment – companies with no real future get billions to invest • Inflated stock prices conceal accounting fraud (e.g., WorldCom, Enron, Global Crossing) • Consumer wealth effect – people spend based on stock wealth that is not there; they don’t have retirement savings when needed • Under-funded pension funds (e.g., Delphi, United, Northwestern, etc.) as pension fund managers had assumed bubble would last • Collapse leads to a demand gap (a.k.a. recession) that is difficult to counteract

  13. How the Housing Bubble Harms the Economy • Overbuilding in housing – due to bubble inflated prices, resources that could have been better invested elsewhere are spent constructing big homes • Consumer wealth effect – people spend based on housing wealth that is not there; they do not have retirement savings when needed • Possible financial panic when bubble bursts, secondary mortgage market (Fannie Mae and Freddie Mac) could be in danger • Collapse leads to a demand gap (a.k.a. recession) that is difficult to counteract.

  14. How the Fed Can Burst Bubbles • It is the Fed’s job – Greenspan intervened to stem the stock crash in 1987. He intervened in the unraveling of the Long-Term Capital Hedge Fund in 1998. The stock and housing bubbles have gar more impact on the economy than either of these events • The Fed has regulatory tools – margin requirements on stocks, lending soundness on housing. • Interest rates – higher interest rates can burst bubbles.

  15. Fed Talk (or Treasury Talk)The Best Weapon Against Financial Bubbles • The Fed chair and the Treasury Secretary have enormous audiences for their pronouncements • If either of them clearly laid out the rationale for a stock or housing bubble (e.g., showed my charts) then every investment manager and financial advisor in the country would have to be familiar with the argument. • Any investment manager or financial advisor who simply ignored these arguments would risk being fired and possibly sued for negligence. • Talk is cheap; why not do it?

  16. Holding the Experts Accountable • It was possible (in fact easy) for any professional analyst to recognize the stock bubble • It is possible (in fact easy) for any professional to recognize the housing bubble. • Custodians get fired when they don’t do their job; why don’t economists, financial analysts, investment managers, and policy analysts? (“Everyone else was wrong too” doesn’t cut it.) • The Congressional Budget Office and Social Security Administration have consistently made stock return projections for Social Security privatization that they cannot support. • CBO over-estimated projected revenues in 2000 by close to $1 trillion over a ten year time frame (0.8% of GDP) because it assumed that the stock bubble would persist indefinitely. (No one was fired.)

  17. Conclusions • It is possible to recognize bubbles – financial markets are not that mysterious • Financial bubbles cause enormous economic damage – far more than modest increases in the inflation rate • The Fed and Treasury can and should act to counteract bubbles • Economists, business, and policy professionals who cannot see financial bubbles should find another line of work

  18. Reading List • Baker, D. and D. Rosnick, 2005. “Will a Bursting Bubble Trouble Bernanke? The Evidence for a Housing Bubble” Washington, D.C.: Center for Economic and Policy Research [http://www.cepr.net/publications/housing_bubble_2005_11.pdf]. • Baker, D. 2002. “The Run-Up in Home Prices: Is It Real or Is It Another Bubble? Washington, D.C.: Center for Economic and Policy Research [http://www.cepr.net/publications/housing_2002_08.pdf]. • Baker, D. 2000. “Double Bubble: The Implications of the Over-Valuation of the Stock Market and the Dollar,” Washington, D.C.: Center for Economic and Policy Research [http://www.cepr.net/publications/double_bubble.pdf]. • Kindleburger, C. 2000. Manias, Panics, and Crashes: A History of Financial Crises. New York: John Wiley and Sons. • Shiller, R. 2005. Irrational Exuberance, Princeton, NJ: Princeton University Press.

  19. Financial Bubbles: What They Are and What Should Be DoneDean Bakerbaker@cepr.netCenter for Economic and Policy Researchwww.cepr.net

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