Since the financial crisis in 2008, interest rates have been suppressed for many years now because of Federal Reserve large scale quantitative easing measures, combined with similar bond buying actions by the European Central Bank and Bank of Japan. The excess liquidity in the market has now inflated stocks to much higher levels. The question remains, are the present market capitalizations of many companies sustainable?
With the election of Donald Trump, the business news media has become enamored with the idea that economic growth can be pushed much higher in the world as new Tax Reform legislation is passed in the U.S. and interest rates continue to remain historically low. Therefore, the market commentary goes, stocks are the best investment, and investors need to “fear missing the chance for much higher returns.”
Anytime the market reaches these types of frenzies, it is best to look at relatively similar situations to see if the hype matches reality over a longer time horizon than 3 – 6 months. As a guide to judge the relative value of stocks and bonds through time, and also to judge whether the market is overpriced, I look at the DOW relative to GDP. Since 1990 the relative level of the DOW index to the US GDP (nominal) is plotted (gray line) in the graph below:
What you can see from the data is that the DOW:GDP line fluctuates through time, and as the market reaches peak time periods, such as the year 2000 and 2007, the measure approached and exceeded 1.0. In fact the index was aggressively higher in the late 1990s.