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Beware of new price bubbles? Not so fast

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With the recent speculative activity in Bitcoin and GameStop, asset price “bubbles” are once again topical. While bubbles seem to be becoming more common, I would say the concept is not very helpful, at least for most investors and government regulators.

During the 1930s, many people viewed the stock market boom of 1929 as a bubble. Then, in the decades following World War II, the bubbles seemed to disappear from public consciousness. In recent decades, soaring stock and real estate prices have sparked new interest in bubbles.

But why do they seem to be more common today? Many people accuse the Fed of creating price bubbles with inflationary monetary policy. But inflation rates for goods and services were much higher during the 1960-90 period, when asset bubbles seemed less common.

The main factor affecting almost all asset markets is the downward trend in interest rates over the past four decades. This decline is not due to monetary policy; rather, it reflects profound changes in the global economy, such as higher savings rates, slower population growth, and a shift from heavy industry to services, all of which tend to lower interest rates .

Lower interest rates can affect the value of assets. Think about mortgage interest rates: when they are low, owning and renting a home becomes more profitable for a given rental income. This creates a new high standard price / earnings ratios in the stock market, as well as higher price-to-rent ratios in the real estate market. These increases in asset prices are not necessarily “irrational” and are indeed compatible with the efficiency of capital markets.

In the housing market, regulations for building housing have become much more restrictive during the 21st century. This means that house prices in many coastal areas are no longer tied to the cost of construction. Instead, with a limited supply of building land, the price can rise as high as demand warrants. Add to that low interest rates and our 20th century assumptions about house prices are simply no longer applicable.

In the equity market, there is now much more uncertainty about the proper valuation of many companies, especially in the “winner takes it all” tech sector. Imagine investors expecting one in every 100 new tech companies to become the new Amazon, with the stock price rising rapidly by 200 and the other 99 failing completely. Should we buy the entire portfolio of 100 shares?

Surprisingly, yes. If the information is correct, this portfolio would double in value, even if all the gains come from a single stock. And until we know which title will succeed, that dynamic can inflate the value of any of them.

The example may seem far-fetched, but this is kind of what happened to investors who bought the entire tech sector in 2000, when the NASDAQ peaked at around 5,000. The index is now close to 14,000, although many individual companies have done poorly. The gains were mainly due to the extreme success of a few companies.

Now consider bubbles from the point of view of “efficient markets theory(EMH), which suggests that asset prices reflect all publicly available information, so it’s almost impossible to know when an asset class is overvalued. Critics of the EMH say that the existence of bubbles proves that markets are often irrational, overtaking fundamental values ​​due to investor “irrational exuberance”. So, who is right ?

It will never be possible to prove that irrational bubbles do not exist. Granted, there are cases like GameStop that don’t seem to fit the EMH. In this case, a recent short press pushed prices to heights that are difficult to explain based on the company’s future earnings outlook. But if we think about why bubbles seem more prevalent today, it’s not clear that the idea of ​​irrational bubbles is useful to investors.

Some investors will make money bypassing GameStop, but others will lose. Some will avoid losses by refraining from buying tech companies that have been overly publicized. Others will miss out on gains by refraining from buying stocks like Tesla and Amazon, and cryptocurrencies like Bitcoin, back in the days when they were already criticized as being too expensive, but ultimately fetched prices a lot. higher.

The new standard of very low interest rates, restrictive building codes and hard-to-assess tech start-ups means that one should actually expect to see a lot more bubble-like patterns, even if the ‘EMH is true and that irrational bubbles do not exist. Some stock and real estate sectors that seemed too expensive decades ago now look pretty reasonable in retrospect.

Here’s the lesson: Policymakers shouldn’t guess at asset market bubbles. Instead, they should focus on things they can control, like using monetary policy to achieve steady, moderate growth in aggregate demand and making sure that banks don’t take socially excessive risks in matters. loan. Let the market set asset prices.

Scott sumner is the Ralph G. Hawtrey Chair in Monetary Policy at the Mercatus Center at George Mason University and Professor Emeritus at Bentley University.


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