By: Lyn Alden

One metric I like to keep track of is the ratio of net worth to disposable income. When the ratio of wealth to income gets very high, it can be a sign that an asset bubble is forming. Regardless, we’re in a period of unusually high valuation during a protracted expansion and investors should have a plan for what they are going to do if this changes.

Most assets directly or indirectly derive their value from income that they can produce, like stocks that produce earnings and dividends, bonds that produce interest, and investment properties that produce rent. When asset prices grow more quickly than the income that they produce, it’s because valuations are increasing.  Thus, investors are paying increasingly more money to own the rights to a given amount of income. And when asset prices are greatly out of line with income, including both investment income and income from wages, it could be a sign of a bubble.

Here’s a chart of the current ratio of net worth as a percentage of disposable income:

FEDweek.com: TSP, are we heading for a bubble?

Source: Federal Reserve Bank of St. Louis

We’ve recently hit a new record in terms of how highly assets are valued compared to the disposable income that Americans have. Net worth is 670% of disposable net income, or 6.7x.

In 2000 – the first major peak in the chart above – stocks were wildly overpriced and real estate was moderately overpriced. In 2007, the second major peak, real estate was wildly overpriced and stocks were moderately overpriced.

In late 2017, stocks, real estate, and bonds are all expensive. More specifically, stocks are far more overpriced than they were in 2007 based on metrics like the cyclically-adjusted price-to-earnings ratio, price-to-book ratio, dividend yield market-capitalization-to-GDP ratio, or any other core metric. Real estate is becoming expensive, but is less expensive in inflation-adjusted dollars than it was in 2007 according to Zillow research.

Everything Bubble?

Bonds have had low interest rates for a record amount of time, meaning bond prices have been unusually expensive compared to the bond interest they produce. Some people are referring to this as an “everything bubble”, meaning everything is expensive. But let’s break this down a bit.

Currently, the United States has nearly $100 trillion in net worth. The total U.S. stock market, approximated by the Wilshire 5000 index, is worth a little under $30 trillion. The total U.S. real estate market, estimated by Zillow research, is worth over $30 trillion. The total U.S. bond market, estimated by the Securities Industry and Financial Markets Association, is over $40 trillion; all together that’s about $100 trillion.

Comparisons are a bit tricky because Americans own some foreign assets and foreigners own some American assets. And people own houses but then owe mortgages to banks, and then own some of those mortgage-backed securities in their 401(k)s and TSPs. But overall, the combined price of stocks, bonds, and real estate is a decent proxy for American net worth.

If the ratio of American net worth to disposable income were to fall from its current 670% down to its historical average of around about 540%, it would be about a 20% decline in overall asset prices, assuming disposable income remains constant. This assumption is reasonable since average disposable income tends to be a very non-volatile metric.

However, stocks and real estate are usually more volatile than bonds, and would probably bear the brunt of any market correction. If stocks and real estate together fall by about 30% in asset prices, and bond prices remain constant, we’d be back around the 540% historical ratio of net worth to disposable income.

It’s important for investors to be aware of risks in the market. With asset prices so high, and considering that we’re almost 9 years into one of the longest bull markets in U.S. history, investors at this point need to have a plan for what they will do if asset prices should fall.

That’s not so say asset prices will surely fall this year or next year, but while we’re in this highly valued territory we need to have plans for what to do when this changes, and be aware that we are indeed in an unusually highly-valued market.