What was different about the 1920s was the narrative. It wasn’t a foreign war story. It was a story of emergence from a “war to end all wars” that was safely in the past. It was a story of the liberating spirit of freedom and individualistic fulfillment. Unfortunately, that spirit did not end well, with both stock prices and corporate earnings crashing catastrophically at the end of the decade.
There was then a period, from 1982 to 2000, when real stock prices increased 7.5-fold while real annual earnings only doubled. The end of this period has been called the dot-com boom or Internet boom, but most of the price growth preceded the tech-driven “new economy” narrative, and declining inflation helped throughout. By 2003, however, both real earnings and real stock prices fell by almost half.
Then, from 2003 to 2007, during a period of gradual recovery following the 2001 recession, real corporate earnings per share almost tripled. But the real S&P 500 less than doubled, because investors apparently were unwilling to repeat their mistake in the years leading to 2000, when they overreacted to rapid earnings growth. Nonetheless, this period ended with the financial crisis and another collapse in earnings and stock prices.
That brings us to the current boom in earnings and prices. Apparently, investors believe that this boom is going to last, or at least that other investors think it should last, which is why they are bidding up stock prices in a dramatic response to the earnings increase.
The reason for this confidence is hard to pin down, but it must be rooted in the public’s loss of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors. Talk of an expanding trade war and other possible actions by a volatile US president just does not seem strongly linked to talk of earnings forecasts – at least not yet.
A bear market could come without warning or apparent reason, or with the next recession, which would negatively affect corporate earnings. That outcome is hardly assured, but it would fit with a historical pattern of overreaction to earnings changes.
Robert J. Shiller, a 2013 Nobel laureate in economics, is professor of economics at Yale University and the co-creator of the Case-Shiller Index of US house prices. He is the author of "Irrational Exuberance," the third edition of which was published in January 2015, and, most recently, "Phishing for Phools: The Economics of Manipulation and Deception," co-authored with George Akerlof.