Should the SARB react to a potential asset price bubble?

Yes the title is slightly misleading - are we sure that there is an asset price bubble? Well, house prices and stock prices have increased, despite low economic growth for the last few quarters. Credit extension to households continue to increase. All of this smells like a bubble.

Let us put our differences aside for the moment and continue from the previous posts regarding the conduct of monetary policy. Should the SARB do something about asset price bubbles? If so, should they prick the bubble, mop up the effects after it bursts or do something else?

I am not sure about the right answer. Roubini believes that central banks should burst it. In it he highlights the reasons for and against (check out the reference list).

I think the SARB is facing one of its toughest trials yet. Good luck!

How do we explain the disconnect between the JSE ALSI and real economic activity?

Strikes are crippling mines, manufacturing and construction are still not recovering, and inflation is high despite low economic growth and lately interest rates increased. Yet, the stock market tells a different story. It is a tale of persistence and defiance.

I have some hypotheses why there seems to be a disconnect between South Africa's stock market and real economic activity: 1.) People are ignoring all the economic warning signs (see previous posts for some of these warning signs) and continue to buy stocks - they love risk, 2.) the stock market is being led by a handful of big companies ,and 3.) the stock market has not caught up with the real economy. So, I did a little bit of digging to find the most probable hypothesis or joint hypotheses.

Hypothesis 1 will be difficult to prove. I assume that most investors do some research before purchasing a stock. When buying a stock they believe in the value of that stock and hopefully did the proper risk adjustments. This value could mean anything from good company fundamentals, to high return prospects. So let us park hypothesis 1 for now.

There seems to be some support for hypothesis 2. Just doing a quick search shows that the big companies (big by market cap) are contributing to the JSE's historic rise. To be honest the last two days were not that great for the JSE's ALSI. What is amazing about these big companies is that they have massive profit margins! How is that possible in an ailing economy? It could be that these companies have great products (better than their competitors, that is if there are any competitors) and that people are willing to purchase these products at current prices (inelastic price elasticity of demand). Or these producers simply make up the core business of South Africa and people don't really have a choice but to purchase their products if it is within their means to do so. I.e. these companies have market power and operate as monopolies or oligopolies (think of SA's banking and telecommunication industries as examples). A lot of these companies are financial companies. These companies in turn need to invest in some real stuff - stuff that has a purpose and can be used. They either invest in commodities, overseas, in other financial institutions or in the companies that have market power (sometimes they will invest in start-ups if there are huge potential returns from innovation).

There seems to be a feedback loop: You and I observe that stock prices are rising and want some of those returns. We go to financial institutions that are more than happy to invest on our behalf, for a price of course. These guys purchase stock from big companies who hopefully use these investments to do some real investments like building power stations or roads or invent something useful. Real investments increase the probability of higher, or constant company growth. A stock would become slightly overvalued if the demand for a particular company's shares increases price without the company being able to indefinitely invest in new ventures that make the company grow. So, it is possible that the growth in stock prices could easily outpace a company's future growth potential. Remember that stock prices ought to reflect a company's growth potential. The price of a stock would be overvalued if it is inconsistent with future company growth - i.e. a bubble waiting to burst.

So can I make a prediction about what will happen to the stock market in the coming months? You can to some degree with a little more research. You will need to scrutinize the big companies' balance sheets and will have to evaluate and understand their expansion scenarios. I don't have the time for that in-depth analysis now.

Bringing this back to an aggregate picture - the macroeconomy as a whole, I would certainly think that the market is overbought (yes of course you will have to look at selected PE, PEG, EPS and whatever other ratios you can think of). I really cannot think that stock prices can rise without it being linked to something real (remember the dot-com bubble), unless there is some financial innovation that I am unaware of. Thus, I think hypothesis 3 also has relevance. Sooner or later the stock market will catch up to the real economy. This is slightly contrary to the convention that the stock market is often a predictor of real activity.

And who knows whether the economy will improve soon - economic forecasts have been all over the place and none hitting the mark. Using two simple statistical models (a Markov-switching and probit model) seems to suggest that the likelihood of another few rounds of bad economic growth is getting higher (a probability of 1 means that growth will definitely be bad). In my view the stock prices will start to fall. But, this is a prediction that only takes into account a few variables - I might have missed something.