February 2016

[admin]

Hadn't seen this one, from Blanchard, no less (just ended his stay as a highly successful chief economist of the IMF):

Are stocks obviously overvalued? The answer is no, and the reason is straightforward. While growth has indeed been weaker than forecast, the rate of return on bonds has also been revised downwards. And what matters for the valuation of stocks is the relation between future growth and future interest rates. Put another way, the equity premium, the difference between the expected rate of return on stocks and the expected rate of return on bonds, has if anything increased relative to where it was before the crisis.

RealTime Economic Issues Watch | Are US Stocks Overvalued?

The last two sets of rows give the equity premium, defined as the difference between the expected rate of return on stocks and the expected rate of return on bonds. In all six cases, the equity premium is higher in 2015 than in 2005. Put another way, stock prices were more undervalued in 2015 than they were in 2005, and after the decline of the past few weeks, even more so.4 You may disagree with the assumptions about dividend growth, and find them wildly optimistic. Or you may disagree with expectations embodied in the yield curve, and believe that real interest rates will be much higher in the future, reflecting higher real rates or higher term premiums.5 But, if you accept current forecasts, and you accept the notion that stocks were not overvalued in the mid-2000s, then you have to conclude that stocks are not overvalued today.

RealTime Economic Issues Watch | Are US Stocks Overvalued?

That is somewhat reassuring, but only somewhat. We see many risks in the world economy:

• Deflationary forces like excessive debt levels and accompanied deleveraging, large and persistent output gaps leading to hysteresis effects (the decay of future production capacity as a result of a reduction of the quality and quantity of production factors due to idleness)
• No obvious motor for the world economy, China's growth deceleration, oil not turning out as a net benefit
• Central bank policies being ineffectual as even in the US, the private sector has a huge financial surplus despite zero interest rates
• Eurozone an accident still waiting to happen
• Processes are feeding on themselves. Low growth and lowflation worsening debt dynamics, leading to more delevaraging, larger output gaps, worsening balance sheets, etc.