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Economy in Brief

"Irrational Exuberance" --- Part 3
by Joseph G. Carson ([email protected])  October 3, 2018

There's an old saying, "fool me once and shame on you; fool me twice shame on me". Yet, who's to blame when it happens a third time?

Soaring equity prices along with continued increases in real estate prices in the third quarter have lifted the market value of household financial and real assets to a new record high, exceeding the relative valuations of the housing and tech-equity bubbles.

The US Financial Accounts report for Q3 issued by the Federal Reserve will not be published until early December but the 7.2% rise in the S&P 500 equity index alone enables one to make some general conclusions. Here's the top three:

*The market value of household real and financial assets will top 6.1 times the level of nominal gross domestic product, a new record high, exceeding the housing peak bubble of 5.8 times in 2006 and the tech-bubble peak of 5.1 in 2000.

*Household's net worth as a percent of disposable personal income should top 700% for the first time, far exceeding the housing bubble peak of 668% of 2006 and the equity bubble peak of 614% of 2000.

*Household holdings of equities owned directly and through mutual funds should equal a record 25% of the market value of household total assets, surpassing the prior peak of 23% reached in early 2000 during the height of the tech-bubble. The one caveat here is that households have a greater percentage of their equity exposure today in mutual funds, suggesting a more passive role but one that still carries substantial downside risk.

The current strong run-up in asset prices represents the third major asset cycle in the past 20 years. Each cycle has unique characteristics, but it also true that each one shares common elements of high levels of consumer and investor confidence and excess liquidity.

Policymakers often state that it is impossible to identify an asset bubble in real time since it is difficult to determine to what extent fast increases in asset prices reflect portfolio adjustments, perceived fundamental changes in the real economy or excess liquidity.

That public defense may have worked following the tech-equity bubble in 2000 but is it that still an appropriate defense in light of Great Financial Crisis of 2007-09 and the fact that in the current cycle monetary policy has flooded the system with cheap money?

The lessons from the past two asset bubbles are quite clear. First, expectations of business profits and market returns outran the economy's potential to deliver, and when the balance of sentiment shifts and investors realize the economy's fundamentals do not support current asset valuations the adjustments can be abrupt and sharp. Second, there is nothing unique about asset markets that would suggest asset prices can absorb an overly accommodative monetary policy and become unhinged from the growth in output and income flows without ultimately leading to costly real and financial adjustments at some point.

Admittedly, it is always difficult to prove causation but it's hard to deny the strong correlation, if not direct link, between the transparent and accommodative stance of monetary policy and the record high relative valuations in the asset markets. If the current asset cycle follows the script of the past two it would appear to reflect the failure of policymakers to recognize that they allowed the cost of credit for real estate and equity purchases to be too low and for too long.

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