Arnold Kling

Bubble Worries

Arnold Kling, Great Questions of Economics
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Brad DeLong writes,

Few people recognize how far out of whack the stock market still is today. Even though stock prices--especially the prices of high-tech stocks--have fallen substantially relative to their early-2000 peak values, there is still a large disconnect between current stock-market values and traditional valuation ratios relative to measures like earnings and dividends.

He points to a column by Dean Baker, warning that advocates of using the stock market to "solve" the social security problem could be miscalculating badly. He sees it as

almost impossible that real stock returns will be as high in the future as the in the past, or even reach the 6.0 percent level that is the central assumption in the actuary office’s analysis of the plans put forward by President Bush’s Social Security Commission.

I do not think you have to go through a very detailed analysis to show that 6 percent real growth in the stock market is not going to happen. The ratio of corporate profits to GDP is approximately constant over long periods. If real GDP grows at a rate of 3 percent for the next twenty years (which is toward the optimistic end of the range of scenarios given by most economists), then corporate profits will grow at 3 percent. That will be the return on stocks. In the unlikely scenario in which the economy grows quickly enough to support 6 percent real returns in the stock market, social security will be solvent no matter how we finance it.

Speaking of bubbles, DeLong points to this Morgan Stanley analysis of the overvalued dollar.

After aggressively accumulating US assets over the past few years, many global investors find their portfolios saturated with US assets... But that said, we are not in the camp of an en masse abandonment of the US credit market. Rather, it’s about saturation and the gradual process whereby foreign investors lighten up their US-dollar holdings.

Discussion Question. How are the high valuations of the stock market and the U.S. dollar related?

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