"Stocks Are Not Overvalued": Supply Siders Drop the (Crystal) Ball Again
Supply siders are always so cocksure of themselves that it is fun to gloat a little—alright, a lot—when their forecasts go awry, which they frequently do. Remember back in 2006 when Arthur Laffer smugly dismissed Peter Schiff's concerns about the housing bubble and assured us that there was no recession on the horizon?
Alan Reynolds, a Senior Fellow at the Cato Institute, is a prominent supply sider. On June 1, 2015, the Dow Jones Industrial Average (DJIA) closed at 18,040 and the S&P price/earnings (P/E) ratio was roughly 22, a 10-year high. On the same day, a CNBC article was published citing Reynolds as arguing that stocks were not overvalued but that interest rates, as measured by the 10-year Treasury bond yield, were too low. While the bond yield was 2.1%, the yield on stocks—the inverse of the P/E ratio—was 4.5%. Referring to a graph he constructed that shows that bond and stock yields both averaged 6.7% over the previous 45 years, Reynolds concluded that the yield on stocks "tends to lead" interest rates and, therefore, that he expected interest rates to rise rather than stock prices to fall. In fact, given low interest rates, Reynolds concluded "we would expect the P/E ratio to be much higher than it is."
As I write this, the DJIA has just shed 256 points on the day to sit at 15,759 and the estimated S&P P/E ratio is19.44 giving a stock yield of 5.1%. The yield on long-term Treasuries is 1.9%. Since Reynolds' forecast, there has been no narrowing of the gap between the yields on stocks and bonds, and only a slight recovery of stocks to their common 45-year average of 6.7%. Clearly stocks were overvalued when Reynolds made his prediction.
The reason why Reynolds' prediction so badly missed the mark is because supply-side economics is almost completely bereft of theory. It asserts little more than the truism that entrepreneurs, investors, workers and consumer/savers respond to "incentives." Thus, in attempting to interpret or forecast economic phenomena, the supply sider is forced to extrapolate past trends. For example, in the 1980s, Laffer, et al. notoriously argued that large government deficits, per se, do not cause an increase in interest rates because such a theoretically sound claim was at odds with "the evidence." Likewise, in his debate with Schiff, Laffer, lacking any insight into Austrian business cycle theory, argued that wealth in the U.S. economy was growing strongly, misled by the increase in prices of real estate and financial assets caused by massively expansionary monetary policy. Laffer displayed genuine befuddlement at Schiff's reply that the increase consisted of "false wealth."
In Reynolds' case, his forecast was falsified by his failure to grasp the difference between observable market interest rates and the unobservable, but theoretically ascertainable, Wicksellian "natural" rate of interest. The natural rate reflects the subjective, voluntary saving or "time" preferences of households-- and therefore cannot be displayed on a graph because it is never realized. The interest rates that we see and record are those that have been distorted and falsified by monetary policy. Thus, stocks and other assets were and continue to be overvalued because market interest rates have been forced down below their natural levels by the inflationary monetary policy the Fed has relentlessly pursued since the financial crisis. Gazing at graphs, no matter how cleverly constructed, can never reveal the theorems and laws governing the dynamic market economy. Theory—specifically Austrian economic theory—is the only tool available for interpreting and forecasting the complex and interdependent patterns of economic activity.