The Federal Reserve is all but certain to raise interest rates on Wednesday, signaling a vote of confidence in the U.S. economy and, by extension, the health of U.S. companies.
The U.S. stock market is already well ahead of the Fed. The S&P 500 is up 6.2 percent since the election through Tuesday despite near-unanimous predictions that U.S. stocks would collapse in the wake of a Donald Trump victory. The index is also up 24.2 percent since it hit bottom on Feb. 11.
The rally has lifted U.S. stock prices to historically high levels. According to Nobel laureate Robert Shiller’s cyclically adjusted price-to-earnings, or CAPE, ratio, they are 60 percent more expensive than their historical average and have been since July. There is such a thing as too much exuberance, however. Stocks have only been as or more expensive three times since 1881, based on the CAPE ratio, and each time has been troubling, historically speaking.
The success of U.S. stocks is not entirely unreasonable. There are good reasons to be upbeat about the health of the U.S. generally and U.S. companies specifically. For example, U.S. companies have been hiring workers briskly, even after accounting for declines in the labor force participation rate. According to the Bureau of Labor Statistics, the U.S. unemployment rate now stands at 4.6 percent. That’s well below the historical average unemployment rate of 5.8 percent since 1948, and less than half the peak unemployment rate of 10 percent just after the 2008 financial crisis. My Bloomberg colleague Barry Ritholtz recently pointed out other reasons to feel good about the state of the union.
But what’s odd about the success of U.S. stocks is that the broader public doesn't necessarily share that enthusiasm. According to the most recent Rasmussen poll, only 35 percent of respondents think the country is moving in the right direction. The recent U.S. election gave voice to that sentiment as voters sent someone who campaigned as an outsider to the White House.
There’s even less excitement for U.S. companies -- the very companies whose stock prices are scaling record heights. According to a Gallup poll in June, only 6 percent of respondents had a “great deal” of confidence in big business, and only 11 percent had similar confidence in banks.
It’s tempting to chalk up this dissonance to a fleeting fascination with U.S. stocks, but there are two reasons why stock prices could hang around these levels for a while longer. First, the CAPE ratio has been persistently high for a long time. The average CAPE ratio was 15 from 1881 to 1994. But that average spiked to 27 from 1995 through November, and that's where it stands now.
There’s also a stubborn home bias in U.S. investors’ portfolios. A traditional stock portfolio typically allocates 70 percent to U.S. stocks and 30 percent to the rest of the world, despite that U.S. stocks account for only 50 percent of the world’s market capitalization. And that likely overstates the U.S.’s longer-term piece of the global pie because U.S. stocks have outpaced overseas stocks in recent years. When that trend reverses, as it always has, U.S. stocks’ share of global market cap will most likely decrease.
It seems to me that both investors and the broader public have it wrong. Call me a cockeyed patriot, but I say that the U.S.’s recovery from the financial crisis has been nothing short of miraculous. If you have any doubt, just look at all the countries around the world still struggling to recover eight years after the crisis. That’s a testament to the resilience of the U.S. economy, its institutions and companies.
Still, that doesn’t justify the stock market's loftiness. Those three times when the CAPE ratio was higher than it is now? On the eve of the Great Depression in 1929; at the peak of the internet bubble in 2000; and just before the 2008 financial crisis. That’s what both investors and the public should be worried about.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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