Moral Hazard and the US Stock Market: Has Mr Greenspan Created a Bubble?

Acknowledgement: We would like to thank participants to seminars at the Bank of Finland and the Warwick Financial Option Research Centre for their comments and suggestions, particularly those from Daniel Cohen and Stewart Hodges. The paper was completed when Marcus Miller was Visiting Scholar at the IMF Research Department and he is grateful for their hospitality. The views expressed are those of the authors, and do not represent those of the IMF. Abstract The current risk premium in the US stock market is far below its historic level and the market continues to rise.. With the long run real interest rate not much, if at all, higher than the growth rate, dividend valuations become very sensitive to variations in the premium: and we show how the latter can be reduced by one-sided intervention policy by the Fed which lulls investors into a false sense of security. We assume investors value their portfolios as if they held a put option, with an exercise price 25% below the previous market peak. Since the Fed cannot determine the real value of stocks, the resulting asset prices are not rational, so our account involves a degree of myopia and over-optimism on the part of the average investor. We provide calibrations to demonstrate that the "sliding put" can reconcile booming stock prices with unchanged risk premia. Although there are some good reasons why risk premia may have fallen below the long run average of 7%, by showing the powerful effect that changing perceptions of down-side risk can exert on asset prices, we have strengthened the case for treating current asset valuations with suspicion. 3 " Beaucoup d'investisseurs ont conclu que les cours boursiers ne peuvent que monter ". Blanchard (1999)