Are there any potential problems of rising stock prices?

The financial easing programs of central banks helped to alleviate the financial crisis that crippled the world. The liquidity generated by these programs did not lead to significant increase in wages or inflation. However, the programs led to substantial liquidity entering the financial markets that contributed to the rise in stock prices. The surge in stock prices may contribute to the creation of asset bubbles, which may lead to correction in stock prices and the emergence of a bear market. This may have spillover effects on the wider economy and contribute to the potential threat of a financial crisis.

The S&P 500 is above 2,700 while the Dow is over 24,500. The TSX is over 16,000. This shows that the major stock indices are very high. The cyclically adjusted price-to-earnings (CAPE) ratio in the US is over 30, which is quite high. While the average CAPE ratio between 1881 and the present has stood at 16.8, it went above 30 only twice, during the Great Depression of 1929 and 1997-2002.–shiller-2017-09 According to Shiller, the average CAPE ratio was 22.1 in the peak time before past bear markets, which suggests that the bear market is preceded by an increase in CAPE ratio. Shiller states that a twenty percent decline in stock prices is widely accepted as an indication of a bear market. The high stock market indices and CAPE ratio indicate that stocks are quite highly priced and a bear market in the future is a possibility.

Various organizations and prominent individuals have also voiced concerns on high valuations of financial assets. Goldman Sachs suggests that there is 88 percent probability of a bear market happening based on the record of previous bear markets. ScoGen states that high valuations of stocks have been supported by low volatility and further decreases in volatility can be dangerous. Germany’s Finance Minister, Wolfgang Schäuble, has voiced concern over rising global debt and liquidity created by trillions of dollars injected into financial markets by central banks which may lead to the creation of bubbles. Professor Richard Sylla of NYU’s Stern School of Business said that similar issues like before the 2008 crisis are happening currently and he suggests that the probability of a financial crisis occuring in our lifetime is between 70 to 80 percent.

Currently, the Chicago Board Options Exchange Volatility Index (VIX) is very low, even lower than before the financial crisis of 2007. Measuring the financial markets’ sensitivity to uncertainty, VIX is known as the fear index. However, Jeffrey Frankel suggests that there are risks which are bursting of a stock-market bubble given the high stock prices and CAPE ratio or an overvalued bond-market and geopolitical risks. It is possible that investors are not taking these risks fully into consideration or underestimating them. This may lead to over-leveraging and the making of a stock market crash. Both Goldman Sachs and JP Morgan have investment products that offer clients a chance to bet on the next banking crisis. When the majority of investors underestimate the risks of a surging stock market, they may continue to chase stocks at ever increasing prices that may lead to an asset bubble. Then, financial institutions may create products to benefit their clients in the event of a stock market collapse.

The Federal Reserve has hiked the interest rate. Also, it announced that it will decrease its $4.5 trillion holdings. However, the S&P 500 and Dow have been increasing. Besides excess liquidity in the financial markets and a clear cut path followed by the Federal Reserve, the rise can be partially explained by a growing economy as well as rising profits of companies. The election of Jerome Powell as the next Chairman of the Federal Reserve may lead to continuity in monetary policy as he is viewed as unafraid of reversing the policy of decreasing the Fed’s balance sheet. Coupled with tax cuts, this will lead to the continuation of the rise in stock prices.

A financial crisis may lead to contagion effects in the wider economy and set in motion ripple effects that lead to the creation of a recession. The effects of a recession are not only economic and financial but also sociopolitical and institutional, which may linger for a longer time than the first two effects. Also, the recovery fueled by low interest rates and injection of liquidity has contributed to increasing inequality while the gains of the recovery have gone mostly to the upper-income group. Therefore, the recovery and, consequent, economic growth has not been that inclusive. Increased investments in education, human capital and infrastructure while removing obstacles like making the tax system more efficient will lead to more inclusive and sustainable growth, and lower income inequality.

When the major economies of the world especially the United States, Eurozone, Japan and China enact structural reforms, it can increase economic growth while decreasing problems in the financial sector. Economic growth will be solid, assets prices will reflect strong fundamentals while inflation will remain at a decent level. On the other hand, without the implementation of major structural reforms and a focus on excess leverage, overcapacity and tax policy geared to favour the rich, asset prices may continue to increase leading to the creation and expansion of bubbles that may rupture and, possibly, lead to deleterious effects for the wider economy.

The injection of liquidity and low interest rate has contributed to rising asset prices and sometimes, real estate prices, as in the case for Canada. Governments have taken various steps to stem rising real estate prices as well as the spiraling prices of stocks. Increases in the interest rate, tough regulations to access mortgage and tax on foreigners purchasing property have been introduced to reduce rising real estate prices in Canada. Again, the Federal Reserve has taken positive steps like raising the interest rate and a plan to reduce its massive holdings to restrain excess liquidity in the financial markets. However, structural reforms like changes in the tax policy that help the low-income and middle-class while encouraging corporations to bring home their overseas profits are required. Again, higher investments in developing human capital, infrastructure, education, healthcare, etc. while incorporating new technology to alleviate the problems in the financial sector and the wider economy will have far reaching effects. It will reduce income inequality which has been a major concern for all countries and reduce prices of financial assets. Then, asset prices will more accurately reflect the fundamentals and the probabilities of the creation, expansion and bursting of stock market bubbles will be greatly reduced. This in turn will reduce the possibility of contagion effects on the wider economy and diminish the chance of a financial crisis.


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