Last week I had the pleasure of appearing as a guest panelist on the Fresh Outlook business news program, where we discussed if the Fed’s massive quantitative easing program created a “bubble” in the U.S. financial markets. Given trillions of dollars were pumped into the economy following the 2008-2009 stock market crash, is the asset class that has been the beneficiary of most of that largesse about to pop?

To figure that out we need figure out which financial asset appreciated the most. At first glance it would appear that the U.S. stock market was the biggest winner, with the capitalization-weighted S&P 500 Index nearly tripling in value from its March 2009 low. More impressively, the tech-heavy NASDAQ Composite has quadrupled in value since then, and even the stodgy Dow Jones Industrial Average has more than doubled.

It’s best to look at increases in absolute, instead of relative, values. In September of 2007 the total value of all U.S. listed companies peaked at $23.9 trillion, but only 18 months later had plunged by 40% $11.7 trillion. Today it stands at $21.7 trillion, nearly twice its 2008 low but still below its highest point in 2007. So the overall stock market has not doubled in absolute value.

On reason is fewer stocks trade today as did before the crash. In 2008, there were 5,603 U.S. publicly traded companies, and three years later only 4,102. That 27% decline is partly because many companies didn’t survive the recession, but also because of mergers and acquisitions.  

And fewer shares trade now than did a few years ago. Many corporations have aggressively bought back their own to drive up their share price, using cash that, because of the Fed’s low interest rate policy, was earning virtually nothing in interest. Fewer shares and fewer public companies have resulted in the impressive gains in the indexes cited above.

That the stock market has appreciated significantly over the past five years does not necessarily point to a bubble. Ultimately, the value of a stock market is measured against the size of the economy in which it operates, and in that regard it may be somewhat overvalued, but nowhere near a speculative bubble. For that to be the case, the U.S. economy would have to contract, which is not out of the question, but also not imminent based on current market conditions.

My response to the moderator’s query was that while all financial bubbles are bad to a degree, in some cases the alternative can be worse. Would you rather have a moderately overvalued stock market today, or a devastating depression starting in 2009?

If a bubble exists, it’s more likely in U.S. Treasury securities.  Buying huge quantities of them was a main way the Fed pumped billions into the economy. That drove up bond prices to what are likely unsustainable levels. However, since the bond market is normally quoted in yield and not price, most investors do not have a sense how overvalued their securities are, and how much potential pain may be involved if prices crash down.

We’ll find out soon enough. The Fed will begin raising interest rates in a couple of weeks, which may signal the reversal of a 30-year downward trend. If so, then one of the biggest financial bubbles of the modern era is about to start losing air, slowly at first and then more quickly as investors grasp the magnitude of its size.

 I’ll be writing more about that in the next two issues of Personal Finance, and in the months to come I will explain what investors can do to prepare for this seismic shift in the financial markets.