Wealth Management: Strategy blog – Are stocks in a bubble?
Strategy team: Victor Balfour
After the fourth quarter’s further gains, there are plenty of signs of US stock market froth: some dramatic moves in high-profile stocks; buoyant IPO markets; and ‘overbought’ momentum indicators. Talk of a ‘bubble’ is growing.
On most measures, US stocks are now clearly expensive relative to their history. The exceptions are those which compare stocks to interest rates and bond yields – which are themselves historically low.
If we were to view the asset class from a ‘top-down’ approach to investment: we would see them as high, but not outlandishly or prohibitively so. Our preferred metric, a “cyclically adjusted” PE (CAPE) which smooths out short-term fluctuations in earnings by using a ten-year moving average, is shown in the chart: its ascent has mostly been less dramatic than the 2000 'TMT' episode, and its level – and divergence from trend – is still significantly less pronounced than then.
“Bubble” is an over-used term, and suggests the imminent permanent loss of most of investors’ capital after a dizzy and exponential surge. We do not think the profile in the chart warrants that label yet. We do think valuations will normalise on a longer-term view, and for that reason the returns we can plausibly expect from stocks are at the low end of the range they should have been in this last decade or so (as we noted in an earlier post). But we think they are still positive, and ahead of likely inflation.
Other measures are shown in the table below. Some are being amplified by earnings’ recent weakness, which is likely temporary. Even a high forward PE may be less significant now, after those earnings expectations have fallen, than it was in 2000, when current and projected earnings had yet to register their looming decline. And if recent economic data are anything to go by, there is a chance that US earnings will rebound more vigorously than analysts currently expect.
Even if valuations were more stretched, they are capable of staying so for a while. Keynes suggested that "there is nothing so dangerous as the pursuit of a rational investment policy in an irrational world", and valuations are rarely the primary cause of a market reversal: they are a notoriously poor market timing tool.
Indeed, US equity valuations have been in ‘expensive’ territory for most of the past seven years: our CAPE has been more than one sigma above its trend for almost the entire period. Meanwhile, the US market rose some 140% (13% annualised).
And though the current multiple (33x) is at its widest spread vis à vis its trend (24x) since the early noughties, as noted we are still some way below that heady ‘TMT’ episode (in both absolute and relative terms). And we can take some reassurance from those low levels of interest rates: they will not disappear overnight, and – as the table suggests – are not fully priced in to begin with (stocks look positively cheap on that basis, not just less expensive).
Looking ahead, the scope for some profit-taking in the short-term must be a near-term risk: a lot of good (or improved) news is priced-in and cash positions are reportedly at their lowest level since 2016 (according to the latest Bank of America Fund Manager Survey – another renowned contrary indicator).
We are trying to stay open-minded: the last decade has not been kind to more dogmatic pundits. Headroom has likely fallen, but this does not look like a bubble to us (and other markets are of course less expensive than the US). Those prospective long term ‘top-down’ returns for equities have fallen, but still exceed both likely inflation and the likely returns on bonds and cash.
Disclaimer
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