What’s with Overvalued Stocks?

Even after the drop in stock prices that came with the bursting of the technical stock bubble, many analysts still consider many equities overvalued. This anomaly requires an explanation, but I have not heard anyone provide one. So perhaps I can.

In a previous posting titled, “Continuous Income Pricing, “ I wrote that “We are told that IRAs are the key to financial security in old age, and these accounts are sold to us on the basis of average returns of the market over selected periods of time. The model is simple. You make regular contributions  which are sometimes matched by someone else, say, for instance, your employer. These funds are then deposited into an account at a brokerage where they are invested in the market. When you reach retirement age, you can then supplement your other income with regular disbursements from your account. All of this seems straight forward enough, but it isn’t. . . . So this, too, is a scheme that guarantees the investor nothing, but guarantees a steady flow of money into the market, where shrewd brokers and professional investors have an opportunity to relieve you of it. And you can be certain that they will if they can.”

Congress has created Individual Retirement Accounts of various types in recent years, and many companies have used these in various ways to replace the company funded retirement plans what were once the norm. As a consequence, numerous people, who otherwise would not have ventured into the market, now not only do so, but do so monthly. The aggregate amount of these investments must be enormous. So the rules of the market which are based on past history have now been upset, since there is now considerably more money chasing stocks that there was before the introduction of IRAs. But the introduction of IRAs did not bring with it a corresponding number of new normal business ventures, although it may have contributed to the bubble in the technology sector.

The result, of course, is more money chasing a relatively static supply, and that increase in demand was bound to push stock prices higher than their valuations would be under traditional terms. In short, IRAs may have created not only the technical sector bubble that burst, it may very well have created a somewhat permanent bubble.

If the American economy does not sustain this the amount of IRA money being invested, this bubble too will burst, and when it does, the losses to individual investors will be magnified by the size of the bubble.

What passes for traditional economics may have been stood on its head, and uncounted economic rules based on past data may now be completely invalid.