We’d Better Hope This Is the Bubble Bursting

Is the stock market too high or isn’t it? Earlier this week, I suggested that share prices had risen higher than companies’ earnings could justify, even by recently inflated standards. But some smart people think current prices are just fine and that they can continue to climb. If they’re wrong, we’re in trouble. If they’re right, we’re probably in a lot more trouble.

As any economics textbook will tell you, share prices are supposed to be proportional to the value in today’s dollars of all a company’s future profits. When the universe is about to end, no one is going to leave cash sitting inside a company; all the profits will be disbursed to investors. When expectations for profits tick upward, so should the share price.

In practice, share prices also respond to supply and demand, and demand for shares in American companies has been enormous in recent years. But as time goes on, and especially as the end of the universe draws near — you can think of it as retirement or death, if you like — the value will eventually rest on the company’s fundamentals.

Right now, those fundamentals look a bit unusual by historical standards. As I pointed out earlier, the Nobel Prize winning economist Robert Shiller’s ratio of share prices to average earnings over a decade (adjusted for inflation) hovered around 15-to-1 from the 1880s through the 1980s. Then the tech bubble hit. At its peak, the ratio came close to 45, but even after the bubble burst a range of 20 to 25 seemed more sustainable. In theory, this was because tech companies were new and wouldn’t have much in the way of earnings for several years to come.

Now, with the ratio close to 25, plenty of smart people think it’s a great time to buy stocks. On Monday, Morgan Stanley put out a “full-house buy signal” — essentially a firm-wide command to invest — for the first time since January 2009. These signals aren’t typically intended to make the firm a quick buck; rather, they suggest assets are significantly undervalued, and there are big gains to come.

How can that be? Some pundits, rejecting a pile of evidence to the contrary, think it’s because investors — individuals and the people served by banks, pension funds, and other institutions — are becoming more farsighted than ever. In other words, they now value profits that will arise in the future more than they did before, or perhaps they just value the future more than they did before.

This seems plausible, since people are living longer (and don’t seem to care as much about their heirs as they do about themselves); for investors today, the universe isn’t going to end quite that soon. In the United States, though, life expectancy at age 30 has only increased by a few years since 1990. It’s hard to believe this small change is enough to justify stock prices being 25 percent higher — that is, a price-earnings ratio of 25 rather than 20.

But if it’s not about how long investors think they’re going to live, what’s the alternative? It could be about how long investors think companies are going to live. The shares of companies expected to last longer are worth more, even if they generate the same profits every year as companies with shorter life expectancies do. It doesn’t matter if a given investor only holds onto the shares for a short time; the point is that someone is always holding the shares, all the way until the company is bought or dissolved.

For example, let’s say that up until the 1980s, investors thought most companies they invested in would only be around for 10 more years. After that, there would be no more profits, so there was no point thinking about them when it came to valuing stocks. Then, in the 1990s, investors decided that companies would be around for 20 years, so many more profits entered the equation. Or perhaps investors just convinced themselves this was true. After all, the promise of longevity was essential to the tech boom — without it, no one would have accepted the airy promises of revenue-free startups.

Indeed, this longevity may be nothing more than a collective delusion. Research conducted just a few years ago suggested that the average duration of companies’ inclusion in the Standard and Poor’s 500 index was actually falling. Globally, the average lifespan of companies also appears to be shrinking rapidly. When companies are simply acquired and subsumed into other businesses, it’s not a problem for investors. But when companies go bust, then the end of the universe is coming more quickly, not less.

Even if this research is just capturing mergers and acquisitions, and companies — not just people — are sticking around longer in some form or other, it could be very bad news. The constant churn of technology, personnel, capital, and management structures is a healthy process for the economy. The longer incumbents sit around, dominating industries and even entire sectors, the less room there is for innovation and entrepreneurship. Will Apple be the dominant force in smartphones in 20 years? You might as well ask why IBM doesn’t dominate the personal computer market or what a Tesla is.

An economy without churn eventually stagnates, as we’ve seen in state-socialist countries and Asian nations that depend on a handful of huge conglomerates. So while those price-earnings ratios may be justifiable right now, they may not be sustainable if the economy stops growing tomorrow. And if investors really aren’t becoming more farsighted in any way, then we’re just in the midst of yet another bubble, at least until a better explanation comes along.

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