Is the US stock market in a bubble?
BUYING stock and holding it for the longer term is a widely accepted conventional wisdom of investment. But what if we're in a bubble?
Firstly, how would we know if we're in a bubble? This is a tricky one: there is no strict universal definition, but experience shows that it's when crowds deviate from their usual patterns and become speculative herds. With this, the investment time horizon (the time you plan to hold your investment) shrinks, and asset prices are bid up to the point where they bear no resemblance to the underlying reality.
Usually, a very powerful narrative or universal belief plays a driving force in the phenomenon. A bubble may be sparked by the promise of show-stopping technological advance (as we saw with the dot-com bubble in 1999/2000); or by widespread belief that house prices would only ever increase (as experienced in the financial crisis of 2008).
Hindsight is a wonderful thing and it's often only after asset prices decline, that the fundamental reality becomes clear. If bubbles were easy to identify, it's likely they wouldn't exist.
Looking at the US market, elevated valuations are the most frequently cited marker suggesting a bubble there. The implicit assumption here is that higher-than-average valuations today must surely “revert to the mean” at some point in the future. On the face of it, valuations are indeed elevated versus history, but assuming they must revert to an historical average is a lazy and frankly dangerous assumption.
There are several solid reasons why valuations in the US should be higher today versus historical patterns. Firstly, price-earnings multiples: these are essentially a shorthand for valuation. Growth is just one component when determining a ‘fair value' multiple; a company's return on capital, as well as the cost of that capital are also important determinants.
This also has implications for an overall index. Tech and related giants have come to dominate the US stock market and as such now make up a large proportion of that index. Generally speaking, these businesses have higher returns on capital, lower costs of capital, and huge growth expectations: all factors which warrant a higher valuation.
The next sensible assertion is an argument that lower bond yields should justify higher valuations. This one isn't entirely true. While it's a fair assumption that lower interest rates should result in higher valuations when all else is equal, right now, all is not equal.
Firstly, there is no strong empirical link between valuations and interest rates. By way of an example, during the dot-com bubble in 1999-2000, valuations reached exorbitant levels in the US and yet interest rates (both nominal and inflation-adjusted) were at much higher levels than they are today.
Secondly, while lower interest rates will result in a lower discount rate (and therefore a higher value of future cash flows today), it is often forgotten that there is a potential offsetting effect from slower expected cash flow growth. It's important to understand why interest rates are falling in the first place.
If not a bubble, how have markets recovered so swiftly?
The short answer is that stock markets are forward-looking. Rather than looking at the short-term impact of the pandemic, markets are acknowledging the recovery prospects in years to come. Looking ahead, the outlook largely hinges on how quickly populations can be vaccinated, and most parts of the world are now making solid progress.
The other thing is that this recession has been anything but normal. It wasn't borne out of financial imbalances due for correction, or excessive speculation. It was a pure external shock. Equally, the response from policy-makers is hard to understate and robust bolstering of household income through government aid will boost a rapid economic recovery.
Investors must detach from the psychology and emotion of any possible bubble and focus instead on doing the maths on future expected returns. When faced with signs of manic speculation, calm-headed investors should ask themselves “how have expected returns and risks changed?”
Of course, no one can say with certainty what future expected returns for the stock market will be (this article would have been a lot shorter otherwise!).
Based on our latest estimates, we still think it is worthwhile for moderate risk investors to hold a reasonable portion of their portfolio in equities, including in the US. As ever, we remind investors that investments can decrease as well as increase in value and a long-term view with a mixed portfolio is the path to stability.
:: Cahir Gilheaney is a wealth manager with Barclays Wealth & Investment Management team in Belfast.