WASHINGTON -- The stock market is going gangbusters -- but whether this reflects the economy's underlying strength or runaway speculation is a question that stumps many experts. Hence, the need for this column: a primer on the red-hot stock market. Will it sustain the economy or ultimately kill it?
The boom is undeniable. In 12 out of the first 15 trading days of 2018, stocks reached record highs, with an overall gain of 6 percent, worth about $1.9 trillion, according to Wilshire Associates. Since Donald Trump's election on Nov. 8, 2016, stocks are up one-third, or $8.4 trillion.
Nor is there much quarrel that, at present levels, stock valuations are "stretched." In layman's language, this means that stock prices are high relative to company earnings (profits). Since 1936, the median price-earnings ratio for the Standard & Poor's 500 stock index is 17; the present P/E is about 24, says Howard Silverblatt of S&P Dow Jones Indices.
Or consider another measure, the "CAPE" index. This stands for "cyclically adjusted price-earnings" ratio. Devised by economists Robert Shiller of Yale and John Campbell of Harvard, it provides a longer view of market behavior. The CAPE averages 10 years of P/Es and corrects for inflation. This index, too, is historically high at 34, which is roughly double the long-term median of 16.
With evidence like this, some experts conclude that stocks are overvalued. Writing in The Wall Street Journal, economist Burton Malkiel -- author of the classic "A Random Walk Down Wall Street" -- asserts that "all asset classes appear overpriced." Economist Mark Zandi of Moody's Analytics says stocks could be overvalued by as much as 20 percent.
What these economists are saying is that euphoric investors are pushing prices higher because they believe everyone else is pushing prices higher. Herd mentality prevails. But sooner or later, this self-deception becomes obvious. Then, stock prices "correct" -- a modest decline of, say, 10 to 15 percent -- or "crash," a much larger loss. Since the 1930s, there have been 13 full-fledged bear markets with declines exceeding 20 percent, according to Silverblatt's figures. Their drops averaged 40 percent.
The counterargument is that something (examples: tax cuts, regulatory policies, new technologies, low interest rates) has brightened the economic outlook, justifying higher stock prices. Trump and his allies have taken this view, arguing that the economy is already strong and that his policies will make it stronger.
One skeptic is Shiller. Although conceding in a recent column for Project Syndicate that high U.S. P/E ratios are a "mystery," he doesn't credit "the Trump effect." For starters, he says, the CAPE ratio has been high since 2013; Trump's policies can't explain this. The market's upward march preceded his election. Nor do high P/Es reflect exceptionally rapid growth in profits, Shiller argues. Just the opposite: Adjusted for inflation, profits are only 6 percent higher than a decade earlier.
The reality is that stock market booms and busts are often driven by financial innovations that initially seem to make investing safer, argues financial consultant Scott Nations in his absorbing new book "A History of the United States in Five Crashes: Stock Market Meltdowns that Defined a Nation (1907, 1929, 1987, 2008 and 2010)."
For example: In the early 2000s, the "securitization" of mortgages -- the packaging of home loans in bond-like securities -- was supposed to reduce risk by informing investors of varying loan quality. Perversely, this lulled investors into a false sense of confidence that justified many dubious loans. When this became clear, the economy and stocks collapsed.
It's an open question whether something similar is happening now. The infatuation with bitcoin symbolizes growing speculation, Nations says. Another source of potential instability could be index products -- exchange-traded funds (ETFs) or index mutual funds -- that allow investors to buy and track a basket of stocks, such as the S&P 500.
These index products have grown rapidly in popularity, reflecting low fees and a belief that most investors can't "beat the market," so why try? In November 2017, there were 1,828 ETFs and index funds worth a total of $3.3 trillion, up from 923 products worth $1 trillion in 2010, reports the Investment Company Institute (ICI), a trade group.
Although index products are investor-friendly, their effect on market trends is not clear. The need to buy and sell huge baskets of stocks may exaggerate swings in both directions, increasing gains in bull markets and losses in bear markets. Still, ICI economist Sean Collins doubts there's much overall impact, noting that -- despite their growth -- index products represent only 13 percent of stock-market wealth.
What seems clearer is that the market remains vulnerable to unexpected economic or political shocks. A significant decline in stocks would undermine confidence and spending. Main Street is, to some extent, hostage to Wall Street.
(c) 2018, The Washington Post Writers Group