The Office of Financial Research published a brief titled “Quicksilver Markets” which asserts that U.S. stock prices today are high by historical standards. The brief uses a quantitative threshold to identify potential stock market bubbles.
The brief, which was authored by Ted Berg, found that markets can change “rapidly and unpredictably,” and that these changes are “sharpest and most damaging” when asset valuations are at extreme highs. The brief notes that these high valuations have “important implications for expected investment returns and, potentially, for financial stability.”
The brief also found that the financial stability implications of a market correction could be moderate due to limited liquidity transformation in the equity market. However, it noted, potential financial stability risks deserve further attention and analysis including those arising from leverage, compressed pricing, interconnectedness and complexity.
Lofchie Comment: It is at least mildly ironic that government economists (who of course do not speak for the government) should identify high stock market prices as a source of market instability. At the same time, federal economy policy has been driving interest rates lower, which in turn drives up stock market prices. And now the prudential regulators seem determined to prevent private investment funds from taking on risk, also potentially boosting stock market price. If government economists now identify the consequence of their regulatory action as market instability, it creates an interesting twist. From a regulatory powers perspective, it raises the question of how much power private decision making should in fact surrender to the government, given that the government may (just like private parties) work at cross purposes.