Thanks to Mike G. for passing this along.
Asset bubbles typically form because of widespread denial, not a lack of obvious signs. In 2000, just before the dotcom stock crash, the S&P 500 index of large American companies traded near 30 times trailing earnings, about double its historic average, but the Internet, some said then, had made price-to-earnings ratios obsolete. In early 2007, before a 30% drop in U.S. house prices, the ratio of prices to rents was twice normal levels, but generous financing and subsidies had supposedly redefined affordability.
A new stock bubble might now be in the making, but this time the signs are less obvious. U.S. stocks, despite having racked up a decade worth of typical gains in the 26 months after their recessionary low, do not look expensive. The S&P 500 trades at 15.3 times trailing earnings, only a smidgen above its historic average of 14.5.
Those numbers might be luring investors toward a cliff, however. History suggests today's corporate earnings are unsustainably high relative to the size of the economy. The real price-to-earnings ratio, based on a more normal level of earnings, is well over 20.
To see why, consider a broad measure of America's prosperity called national income. It consists of corporate profits, worker wages, sole proprietor income and more. Corporations and workers compete against each other for income but also rely on each other for success. When profits and wages grow in tandem, the result is healthy economic expansion. When one grabs too large a slice of the nation's income pie, it usually signals a downturn waiting to happen.
For example, corporations since 1929 have collected an average of 6.4 cents per dollar of national income as after-tax profits. In 1966 corporate profits swelled to 8.3 cents per dollar of national income; they then fell 19% by the end of the decade. In 1997 they were 8.6 cents per dollar of national income; by the end of that decade they were down 13%.
Last year corporate profits reached 9.4 cents per dollar of national income. That's 47% too high by historic standards. If earnings were to shrink to their historic average, the aforementioned P-E ratio of 15.3 for the broad stock market would rise to nearly 23. The result would almost surely be a plunge in share prices.