Are we in a stock market bubble?

This is the worst time to invest in the stock market if you prefer owning underpriced companies. According to Yale economist Robert Shiller, who won the Nobel prize for economics in 2014, the market is way overpriced. Shiller’s price-to-earnings ratio, which measures a stock’s price relative to the last 10 years of the company’s earnings, hit a level not seen since the early 2000s.

This is the still a good time to invest in the stock market if you believe that the Federal Reserve’s loose monetary policy will overheat the economy, which could spark inflation. I believe that the Fed was responsible for the 2000 tech bubble and the 2008 housing bubble. In both cases, the central bank was slow to recognize that poor fiscal policy would ignite speculative excess. The third time might be the charm.

This week the Federal Reserve raised short-term interest rates by a quarter of a percentage point. This increase was expected. The real shock came after the meeting when Janet Yellen was speaking to reporters and said that the central bank was willing to tolerate inflation temporarily, overshooting above its 2 percent goal and that it intended to keep its policy accommodative for “some time.” Two percent is a target, she reiterated, not a ceiling. The stock market cheered her change of heart.

Interest rates had already been on an upswing following the election of Donald Trump as president. Prior to the election, 30-year fixed mortgage rates was 3.50% and now it’s at 4.25% (Leaders Bank). U.S. Interest rates would be much higher if overseas rates were not negative. The 2-year German Bund is at -0.81%. Investors are actually willing to lose money not to take risk.

While I’m in full agreement with Schiller’s warnings, I continue to believe that stocks continue to offer the best hedge against inflation. The best way to explain my reasoning is through a few examples. Recently, a client asked whether a 2% CD maturing in 5 years was a good deal. My answer was if the Fed is willing to tolerate inflation above 2% then buying this CD could eventually result in a loss of purchasing power. Another client inquired whether a 4% fixed annuity was a wise choice. It seems like a deal today, but what happens if interest rate rise by 1-2%? The Fed is expected to raise rates by this amount over the next few years. This retiree might be better off waiting and buying corporate or municipal bonds in a few years. This would allow them to keep the principal of their investment rather than donating it to the insurance company.

Please consider your own personal circumstances and risk tolerances before taking advice through a blog. But in the cases for these clients, the answer was clear. At some point, Shiller will eventually be proven correct, but I believe it will be when interest rate and inflation rates are much higher.

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