As far as Harvard economist Martin Feldstein is concerned, we're all doomed.
Feldstein says that the low interest rates of the last several years have created a stock market bubble rivaling the housing bubble that precipitated the last crisis. As interest rates keep rising, he says, the stock market bubble will eventually burst, sending the economy into another "long and deep downturn." But, unlike in the prior recession, with interest rates still relatively low, the Federal Reserve will have less room to respond to a weaker economy.
We have to admit to feeling a little awkward disagreeing so strongly with Feldstein. He's been a long-time advocate of lower tax rates and less government spending, policy positions near and dear to our hearts.
But, when it comes to forecasting what the economy will do in the next few years, we think he's laid an egg.
Why? Let's start by looking back. We like to assess fair value in residential housing by comparing the asset value of owner-occupied homes to the annualized rent these homes could earn. Using historical averages, our calculations suggest home prices were about 40% above fair value at the end of 2005. With US homes valued at about $21 trillion, that meant an overvaluation of about $6 trillion. (Note: When an asset is priced 40% too high, it takes a loss of 28.6% from the overvalued level to bring the price down to fair value.) For perspective, GDP was $13 trillion that year.
By contrast, the stock market is not even close to that kind of overvaluation. At present, the price-to earnings ratio on the S&P 500 is 22.3. The average in the past 40 years is 20.2. So even if you accept the P-E ratio as the gospel (and we don't), equities only appear about 10% over-valued.