Here is an article from the The Economist's 'The World in 1999'. The reasoning should be pretty accessible for you. According to the Economist writer, Japan and Euroland (the region covered by the Euro, ie., mainly the continent of Europe) save a lot (positive current accounts) and the English speaking world (US and UK, mainly) save very little (i.e., have negative current accounts). The writer says that the US stock market 'bubble' will burst soon, with stock prices falling sharply. Then, US citizens will raise their saving rate (i.e., the rate is s and total saving, S, is S=sY..they will increase s from s1 to s2, where s1<s2), as they feel poorer. Since the US is so big this corresponds, in effect, to an increase in the world saving rate. Then, following standard closed economy IS-LM reasoning, The Economist concludes that the world will lapse into recession. With investment opportunities, I, in the world fixed, world income, Y, will have to drop from what it is now, Y1, to Y2, so that s2*Y2=s1*Y1 equals the (presumed) unchanged I. This is just standard 'paradox of thrift' reasoning from Economics C11.

The article raises various issues. The writer bases the idea that there is a 'bubble' in the stock market on something called q-theory. This theory actually has a lot of empirical problems, despite the glowing review in the article. Still, let's suppose it's a great theory. As noted in the article, Tobin's q is the ratio of the the value the stockmarket places on the productive capital (like machines, buildings, etc) of corporations and the amount it would cost to replace all these productive assets at today's prices. According to The Economist, the value of  q is now very high. The writer emphasizes one interpretation, namely that the value of corporations on the stockmarket is somehow 'too' high, and therefore that there will soon be a tremendous downward correction.

Although The Economist may well turn out to be right, there is nothing in the logic of the article that requires it.

That's because the article does not rule out another possibility. The high value placed on corporations may reflect that the market thinks they're doing all sorts of wonderful new things with their productive capital, for example in implementing the new 'Information Technology Revolution'. If that is so, then the high value of q actually signals that investment will be high. In fact, this is what a conventional application of q theory would actually deduce. A high value of  q means that the value of productive capital to a firm is higher than what it costs. According to q theory, this means that profit-maximizing firms will soon buy lots of new capital. This is just standard economic reasoning - when the benefit of something exceeds the cost, do it!

So, another interpretation of the high value of q is that we will soon see an investment boom, with the world economy taking off!

Of course, the stock market has been high for quite some time (Greenspan's famous speech 'wondering' whether the then high strong stock market reflected 'irrational exuberance' was made in 1996). Has investment been high? According to a Federal Reserve Bank of Chicago article by Francois Velde, the answer is 'yes'. But, it turns out that arriving at this answer is a little tricky. That's because spending on I, as a fraction of total GDP, has actually fallen since the early 1980s. But, as Velde points out, the fact that you spend less on something does not mean you're necessarily getting less of it. You can reduce your spending on something and get more of it, if it's price falls by enough. And, that's exactly what investment good prices have been doing, falling a lot (when it comes to computer and other electronics goods, this should be obvious). Velde shows that the falling price of investment goods translates into a surge in purchases of investment goods in the 1980s and 1990s. So, there is some evidence supporting the optimistic interpretation of recent movements in Tobin's q.

Note: the current debate about the 'overvalued' stock market is almost exactly the same as a debate that occured in the 1920s. At that time, the stock market was soaring, with some people saying it was a bubble and others saying it was driven by fundamentals. The Federal Reserve at the time was very concerned about the possibility that it was a bubble and moved aggressively to 'prick' it by raising interest rates in 1928 and 1929, especially late 1929. It was just after an especially large interest rate hike that a major stock market crash occured. Irving Fisher was perhaps the most famous person arguing in the 1920s the view that the stock market was driven by fundamentals. His idea was that since 1919, had been an explosion of new ideas in the economy and that this gave rise to a relatively large fraction of firms whose earnings were currently low but expected to be high in the future. This was Irving Fisher's explanation of the high P/E ratios (P - price of stock, E - current earnings of the underlying firm) observed in the 1920s. Irving Fisher's argument is very similar to the arguments of people today who say that P/E ratios are high because of the explosion of ideas associated with the 'Information Technology Revolution'.

What do the historical data say about the stock market implications of a high P/E ratio? The highly regarded economist, Robert Shiller, addressed this question in 1996, and concluded that a high P/E ratio signals that the stock market will be weak in the following decade. His advise was to avoid stocks. At the time that Shiller wrote, the Dow was somewhere in the range of 5,000 to 6,600. Now it is over 10,000. Shiller may well turn out to be right (the decade is only 40% over), but the Dow would have to perform VERY badly in the next six years for him to be right. For another piece on the 'overvalued' stock market, see Brad De Long.