Robert Samuelson December 4, 2013

The question about the stock market is whether the bull is a bubble.The 1990s’ “tech bubble” and the recent “housing bubble” haveconditioned us to think that almost any sign of investor craziness isgoing to end badly — and the stock market seems a bit crazy. At the endof November, reported Wilshire Associates, stocks were up nearly 30 percent for the year, representing a gain ofabout $4.8 trillion. From the market’s recent low in March 9, 2009, when the economy was in a tailspin, the increase has been 180 percent, ornearly $15 trillion. If you dislike this comparison, then measure thegain since the market’s pre-recession high on Oct. 9, 2007. The increase is 21.5 percent, or $4.2 trillion.

What’s more, there’s a widespread expectation that stocks, despitetemporary setbacks, will continue to advance. After all, the FederalReserve is pumping $85 billion a month into financial markets — about$1 trillion a year — by buying bonds. Much of that money (the theory goes) props up stock prices.

The impending change in leadership from Ben Bernanke to Janet Yellen as Fed chairman is viewed positively. Yellen will wait longer, it’s said, toreduce the Fed’s pump-priming. As a Wall Street Journal headline put it: “ ‘Dovish’ Yellen Keeps Gloom at Bay: Incoming Fed Chairwoman’s Message Has Given Comfort to Investors and Fueled Stocks’ Resilience”

Still, all the happy talk will be just that if the market’s surge turns out to be a bubble, which — once burst — wrecks confidence and, perhaps,converts the plodding recovery into a new recession. So, is today’smarket a benign boom or a bad bubble?

Here are three crucial facts.

First, investor sentiment has clearly shifted toward optimism. One survey offinancial newsletters finds that 57.1 percent are “bulls” (expectinghigher stocks) and only 14.3 percent are “bears” (expecting lowerstocks). The ratio of almost 4-to-1 is the highest since March 1987,said economist Edward Yardeni of Yardeni Research.

Among his clients — pension funds and other large investors — “there’s lessanxiety and more willingness to see the upside,” he said. “When wedidn’t go over the ‘fiscal cliff’ [the cancellation of all the Bush taxcuts] at the beginning of the year, there was a huge sigh of relief.People had anxiety fatigue. . . . No one talks anymore about the disintegration of the euro zone.”

Of course, the optimism could cut either way. It may indicate that soberanalysts agree that stocks are a good buy. Or it could signal that greed and crowd psychology have taken charge.

Second, the market’sgains are not unusual. Following deep declines, stock rebounds are often large. Since 1932, there have been 13 bull markets, defined as gains of more than 20 percent, according to Standard & Poor’s. For all bullmarkets, stocks have risen an average of 165 percent based on theS&P index of 500 stocks. Stocks’ present increase through Novemberis 167 percent (the S&P index differs slightly from the Wilshireindex cited earlier). By itself, this year’s gain doesn’t suggest anovervalued market.

Finally, growing profits explain much of themarket’s increase. In theory, stock prices reflect present and futureprofits, and — despite a sluggish economy — corporate profits haveincreased impressively. By government figures, they’re up 39 percentfrom their 2006 pre-recession peak. Profit margins are near recordlevels, about 9.6 percent of corporate revenues, noted S&P’s HowardSilverblatt. Higher profits have kept a key stock market indicator — the price-earnings ratio — well within historical norms, found a study bythe McKinsey Global Institute, the consulting company’s research arm.

What’s unclear is how much the Fed’s bond-buying, called quantitative easing, has boosted stocks.

Zilch, said economist Susan Lund, co-author of the McKinsey study. “There’s ashort-term effect, but then the market reverts to long-term trends,” she said. Improved profitability explains stocks’ rise. If true, cutbacksin quantitative easing won’t much affect stocks.

Silverblatt wasless sure. “Definitely the Fed helps,” he said. “There’s more buying,but quantifying [the benefit] is difficult.”

What’s clearer isthat stocks and the “real economy” of jobs and production have becomedisconnected — and that this cannot continue indefinitely. There arepractical limits to how much companies can improve profits withoutstronger economic growth and higher sales. If these don’t materialize,we may discover that the market is not a bubble but a blob that goesnowhere quickly.

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