Yes, the stock market is booming. No, it isn’t a bubble.

January 23, 2013

One of the biggest trends underlying the strengthening of the U.S. economy has happened so gradually, and with so little discussion, that it was easy to miss. But facts are facts, and while many people didn’t notice it, the U.S. stock market has been on an absolute tear, rising back to near its pre-crisis level.

Tuesday was a typical day in this long rally, which has proceeded with only a few interruptions since March 2009. The Standard & Poor’s index rose 0.4 percent, enough to make Americans’ 401k accounts a little bit more flush, but not dramatically enough to prompt any outpouring of celebratory confetti or even a hint of the bubble-era mentality that flourished in the late 1990s (The TV ad for a brokerage in which a tow truck driver hit it rich day trading is but a distant memory).


The Standard & Poor's 500 is almost . . . all . . . the . . . way . . . back

But add up those days of 0.4 percent gains—there have been a lot of them in the last four years--and it is a remarkable run. Tuesday’s close left the S&P only 4.6 percent below its all-time high in October 2007, meaning it could enter record territory after just a couple more good days. We are living through the strongest stock market rally since the late 1990s--though this one has far, far more solid fundamentals underlying it.

The rise is a major, major reason that Americans’ household finances are looking better.

Stock investments and mutual funds only amount to about 20 percent of Americans’ assets, according to data from the Federal Reserve; much more of their money is tied up in their houses, other physical assets like cars, bank accounts, life insurance policies, and the like. Yet between 2008 and the third quarter of 2012, they accounted for 59 percent of the $10.6 trillion rise in American households’ assets. Americans—at least those with significant savings—are feeling wealthier, and the booming market is a big part of the reason. Household real estate, by contrast, is still worth less than it was in 2008 even after edging up recently.

The last time the S&P lodged a four year gain as strong as the current run was from late 1996 to late 2000, which was, with hindsight, a time of an epic bubble. Given that the current market boom has been fueled in no small part by easy money policies out of the Federal Reserve, there’s some simmering worry that this too is a bubble—perhaps that the minute the Fed starts inching away from the era of cheap money, the whole thing will collapse in upon itself.

But there’s good evidence pointing to this not being the case.

The key thing to know is that American businesses have spent the last four years becoming much more profitable. Tabulations by Bloomberg News, based on 11,000 analyst estimates, found that 2013 earnings for the Standard & Poor’s 500 are expected to be about $1 trillion, 31 percent more than the 2007 peak. If you’re an investor buying into the stock market, you are getting much more earnings power out of Corporate America at a lower price.

Market mavens often speak of the “price-earnings” ratio as a way of assessing whether the stock market is undervalued or overvalued; for the S&P, it currently stands at 14.8. But I find that it can be more intuitive to look at the inverse of that number, the earnings-to-price ratio, which is also known as the stock market’s earnings yield. Do that math (divided 1 by 14.8), and you see that the S&P is yielding 6.7 percent right now. In other words, for every $1,000 a person invests in America’s largest companies, they recorded earnings of about $67 for the year.

Now compare that yield of 6.7 percent to what a risk-free asset is paying right now. For 10 year Treasury bonds, that's 1.8 percent. The gap between those two numbers, nearly 5 percentage points, is, in effect, the extra compensation investors receive for investing in risky stocks instead of safe bonds. Even before accounting for the fact that corporate earnings rise over time while bond coupons are unchanged, that is a remarkable premium—and one that suggests that stock investors are being well compensated for the risk they are taking on.

For comparison, look at what that same gap (the equity risk premium, to use the finance geek term) has been at some other key moments. In the summer of 2007, the stock market earnings yield was 5.8 percent, lower than it is now, though not drastically so. Yet at the time, 10 year Treasury bonds were yielding 5.1 percent. In other words, investors were so complacent about risk, so confident that corporate earnings and the stock market as a whole would keep rising indefinitely into the future, that they were willing to by stocks for only 0.7 percent more than the yield they could receive on Treasury bonds. Of course, they were wrong, and anyone who shifted money at that time into Treasuries, and kept it there, has made a boatload.

And the current boom has almost nothing in common with the bubble that ended in March 2000. At the peak of that boom, the S&P had an unprecedented price to earnings ratio of 31.4, which translates into a 3.2 percent earnings yield. At the time, Treasuries were yielding 6 percent. In other words, investors were so insanely confident that corporate earnings would skyrocket in the future that they were willing to accept a nearly 3 percent lower yield than they could gain from ultra-safe bonds. Instead of being compensated for taking extra risk by investing in the stock market, investors were sacrificing 3 percentage points of yield in exchange for joining the great Internet hype machine.

Now that was a bubble. What we’re seeing now is a stock market boom that is simultaneously driving Americans’ wealth higher, supporting economic growth, and is well-supported by the fundamentals of what companies are earning.

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Dylan Matthews · January 23, 2013