The Late Twentieth Century Great Growth Bubble

Abstract

This article reviews stock market valuations focusing on value and growth forecast returns. There are three basic rationales for the stock market valuations that we saw at the close of the 20th century; an “earnings growth argument,” a new lower equity risk premium, or irrationally priced stocks—i.e., we are in a classic bubble. We argue that for the earnings growth argument to be true, earnings for companies in stock indexes would have grown to an unprecedented and unrealistic share of U.S. gross domestic product. While investors may have adopted a newer and lower equity risk premium, the second argument, we argue that the premium is too low for growth stocks—too low in fact to be reasonable. We opt instead for the irrational price explanation. The idea of a ceiling on earnings growth and a floor for the equity risk premium outlined here is useful for investors establishing boundaries for expected equity returns.