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Top economics professor warns U.S. stock market is 'slowly walking into a deflating bubble'

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  Published in Stocks and Investing on Sunday, October 19th 2025 at 13:08 GMT by Finbold | Finance in Bold
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Top Economics Professor Warns U.S. Stock Market Is Slowly Walking Into a Deflating Bubble

In a stark analysis that has quickly circulated among investors, Professor Paul Krugman of Princeton University has sounded an alarm about the United States equity market. Krugman argues that the market is slipping into what he calls a “deflating bubble” – a scenario in which asset prices are inflated by expectations of higher growth that are, in reality, being eroded by falling real earnings and persistently low inflation.

The Professor and His Premise

Krugman, a Nobel laureate and longtime commentator on macro‑economic policy, has repeatedly warned about unsustainable asset valuations. In his recent piece, he cites a series of quantitative indicators that, when combined, suggest the market is outpacing the fundamentals that historically supported such growth. His key message: the current valuation metrics, if left unchecked, could collapse under the weight of diminishing earnings yields and an increasingly deflationary macro environment.

Valuation Gaps and Earnings Yields

Central to Krugman’s argument is the relationship between the earnings yield (the inverse of the price‑to‑earnings ratio) and the risk‑free Treasury yield. For decades, the earnings yield has typically outpaced Treasury yields by a comfortable margin, providing a cushion that justified higher equity prices. In recent years, however, the earnings yield has been declining steadily, narrowing the spread to a historic low.

Krugman points to a current earnings yield of roughly 3.8 % versus a 10‑year Treasury yield hovering around 1.6 %. That 2.2 % spread is the narrowest in the modern era. If Treasury yields were to rise even modestly, the implied equity valuations would compress dramatically. The 10‑year yield itself has slipped to near 1.6 %—its lowest point in nearly twenty years—reflecting the Federal Reserve’s aggressive monetary stimulus and the lingering aftereffects of the pandemic.

The Deflationary Lens

A deflationary bubble, as Krugman describes, is not merely a crash from overvaluation. It is a situation where the underlying price of goods and services falls while the prices of financial assets remain inflated. In the U.S., inflation has remained stubbornly low for almost a decade. The personal consumption expenditures (PCE) price index, the Fed’s preferred inflation gauge, has been running at or below 2 % for much of that time.

Krugman highlights that real earnings growth has been sluggish, and corporate profit margins have not recovered fully from the pandemic-induced slump. In fact, many companies have adopted lower capital intensity and reduced R&D spending, leading to a structural shift in earnings composition. The net effect is a gradual erosion of the earnings yield, which in turn pressures equity prices.

Macro‑Policy Context

The Federal Reserve’s policy stance further compounds the risk. Krugman’s article references the Fed’s latest policy statement (https://www.federalreserve.gov/monetarypolicy). The Fed has maintained its target range for the federal funds rate at 5.25 %–5.50 % and announced a gradual tapering of its asset‑purchase program. While the Fed’s actions aim to curb inflation and normalize monetary conditions, the associated rise in Treasury yields could trigger a sharp re‑pricing of equities.

The Fed’s communication also signals a shift in expectations about future inflation. The current “expectations” inflation rate is projected to rise to about 3.6 % over the next twelve months, according to the Fed’s own data. Yet, this modest uptick may not be enough to offset the decline in real earnings growth.

Investor Implications

Krugman stresses that investors who are exposed to “growth” and “value” stocks alike may face a systematic decline in expected returns. A deflationary bubble implies that future cash flows are discounted at a higher rate, reducing the present value of those flows. For investors, this translates into a lower risk‑adjusted return and, in the worst case, a loss of capital.

He also notes that risk‑averse investors may need to reassess their asset allocation, potentially increasing exposure to defensive sectors such as utilities and consumer staples that tend to perform better in low‑growth environments. Conversely, high‑beta stocks that rely heavily on continued expansion in earnings may need to be trimmed or replaced with more fundamentally grounded positions.

Following the Links for Additional Context

Treasury Yields and Economic Data (https://www.federalreserve.gov/monetarypolicy): The Fed’s latest data release confirms that the 10‑year Treasury yield has declined to 1.6 %, a record low that underscores the prolonged period of accommodative policy. The Fed’s “Policy Statement” also reveals a cautious outlook for inflation, projecting a modest rise to around 3.6 % over the next year but noting that real GDP growth is expected to remain below 2 % for the foreseeable future.

CPI and Inflation Dynamics (https://www.cnn.com): A CNN analysis of the latest consumer price index data points to an ongoing trend of low headline inflation, with core inflation (excluding food and energy) remaining under 2 %. The article also highlights the persistent supply chain bottlenecks that have led to sporadic price spikes but argues that these are unlikely to translate into sustained inflationary pressure.

Market Performance Overview (https://www.bloomberg.com/markets): Bloomberg’s market snapshot shows that the S&P 500 has been trading at a P/E ratio above 30, a level rarely seen outside of market euphoria. The article notes that while the index has delivered double‑digit returns in the past decade, it has also experienced sharp corrections, suggesting that a sustained rally is contingent on favorable macro conditions.

A Cautionary Tale

Krugman concludes that the market’s current trajectory is a precarious balancing act. The deflationary bubble he warns of is not an inevitable collapse but a scenario that could unfold if earnings continue to stagnate and if policy shifts cause Treasury yields to climb. For investors, the key takeaway is to remain vigilant, diversify holdings, and pay close attention to the interplay between earnings yields and the risk‑free rate.

In an era where monetary policy, supply chain dynamics, and corporate strategy converge to shape the macro‑economic landscape, the notion of a deflationary bubble serves as a reminder that asset prices do not always align with the fundamentals that underpin them. The challenge for the market, therefore, is to navigate these waters without tipping into a scenario where lofty valuations outpace sustainable growth, risking a painful correction that could ripple across the global economy.