The Federal Reserve Board and the Stock Market Bubble: The Relationship Is More Complex Than It Appears

By England, Spencer F. | Business Economics, April 2003 | Go to article overview

The Federal Reserve Board and the Stock Market Bubble: The Relationship Is More Complex Than It Appears


England, Spencer F., Business Economics


The stock market rose to unprecedented valuations in the late 1990 and was widely considered to be a bubble. The Federal Reserve Board has come under severe criticism recently for causing the bubble and has felt compelled to defend its record. Monetary policy has long been considered a major factor driving the stock market P/E. But how monetary policy impacts the market is more complex than the Federal Reserve Board and its critics realize, and both have made major analytical errors. A simple adaptive behavioral model that uses the percent of the time the market has been in a bull market over the prior twenty years as a measure of the risk premium, as well as interest rates and inflation, demonstrates that an S&P 500 P/E of over twenty is justified and why the relationship between interest rates and the market P/E underwent structural changes in the late 1950s and 1990s. It also shows that if the Federal Reserve Board had tried to prick the 1990s market bubble they would have had to raise rates enough to seve rely damage the economy. Results from the model also carry major implications for the future relationship between monetary policy and the stock market.

**********

The Federal Reserve Board is now coming under so much criticism and blame for the stock market bubble and its aftermath that it has felt compelled to defend its record. But the Board and its critics have made critical analytical errors on both the stock market bubble and the weak performance of the economy. Until recently, these errors had little impact, but now they may be contributing to monetary policy being too tight.

The one clear measure of the market bubble is the market price-to-earnings ration (P/E). (1) It has been greater than twenty on trailing operating earnings since mid-1997. This is the only time in history that an S&P 500 P/E above twenty has been sustained. It had only been above twenty some five times before--1929, 1938, 1946, 1962 and 1987. Each of those times it was above twenty for only a very short period, and each episode preceded a major stock market crash. Actually, if one had put all assets into cash in June 1997, when the P/E rose above twenty, they would now have higher returns than if they had ridden the market up and back down.

The market P/E is generally viewed simply as a valuation measure, but it is much more than that. It represents what investors are willingly to pay for growth at any given time. The P/E of both the market and individual stocks is a function of their expected growth rate. A low grower will sell at a discount to the market P/E, and a superior grower will sell at a premium. Changes in P/Es- are largely governed by the rules of present value analysis and compound interest rates. Bull and bear markets are almost exclusively a function of P/E expansion and compression rather than earnings changes. Thus, a bear market results when the perceived present value of the future stream of income falls, and a bull market results when the perceived present value of that income stream rises. Also, the higher an individual stock's P/E, the more severe will be the impact of a change in the market's PIE on its own PIE. For example, if the market P/E is cut in half, a growth stock's P/E might fall two-thirds, while a value stock's P/E would only fall one quarter. Thus, growth stocks outperform a bull market and under perform a bear market.

Figure 1 shows that from 1991 to 2000, S&P operating earnings per share grew at a 12.5 percent annual average rate, a rate significantly higher than its post-World War II era seven percent long-term trend. Moreover, during the same period productivity broke out of its 19741995 trend of only 1.5 percent growth versus its earlier long-term three percent trend. Wall Street quickly pounced on these shifts as evidence that we were in a new era of permanently higher earnings growth and incorporated double-digit earnings growth trends into long-run earnings forecasts. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

The Federal Reserve Board and the Stock Market Bubble: The Relationship Is More Complex Than It Appears
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.