X

Mortgage & Property

New Insurance Professional

Family Office Bulletin

Mortgage Property

Insurance Professional

Family Office

Are we in a bubble?

William Ryder , Equity Analyst at Hargreaves Lansdown examines market valuations

“Veteran investor Jeremy Grantham at GMO recently published a widely circulated research article arguing that the “long bull market since 2009 has finally matured into a fully-fledged epic bubble.” Specifically, he was talking about the US stock market. The market is, on some measures, relatively highly rated when compared to its history. And there’s a fair degree of euphoria around certain individual companies and sectors. But that doesn’t necessarily mean we’re in a bubble, or even that stocks are overvalued.  Instead you could argue the decline in interest rates since the 1980s explains and justifies the market’s higher rating. And therefore a large part of the performance since the Financial Crisis. Of course, individual stocks or even whole sectors could be over or under valued.

The idea that we’re in a bubble comes from a few places:

  1. Stocks have had a fantastic run for a little over a decade now. Since 1 March 2009, after the Financial Crisis, the S&P 500 has returned 560% including dividends.
  2. The US market currently trades on a cyclically adjusted PE ratio (more on how this works later) well above its long run average, even though the real economy has suffered one of the biggest shocks on record.
  3. Perceived enthusiasm and excessive optimism among investors.

Bubbles make people nervous because they have a habit of bursting. However, you need to analyse the risks carefully, as investors may miss out on strong bull markets through excessive caution.

The Cyclically Adjusted Price Earnings Ratio 

A normal price/earnings (PE) ratio is simply an investment’s price divided by its earnings or profits, in this case the S&P 500. However, company profits vary from year to year, so a PE ratio can often be misleading if earnings are unusually and unsustainably high or low. For example, earnings at many companies were significantly reduced in 2020 by the coronavirus pandemic. A simple PE could be misleading if investors expect earnings to recover.

Nobel Laureate Robert Shiller popularised dividing the price of the index by the average of its earnings in the last ten years, all adjusted for inflation. That way cyclical ups and downs in earnings are smoothed out to give a less jumpy picture of the market’s valuation. This type of PE ratio is called a Cyclically Adjusted PE, or CAPE, ratio. You may also see it called a Shiller PE ratio.

Shiller has calculated this ratio for the US stock market back to 1881, giving us a lot of data to work with.

Source: http://www.econ.yale.edu/~shiller/data.htm, 14/01/21

 

The US stock market has only been this highly valued twice before: during the Dot Com Bubble in the late 1990s and before the 1929 market crash signalling the beginning of the Great Depression.

Graphs like this make people nervous, mainly because they believe that the market is likely to revert to its long run average. However, interest rates have also fallen precipitously in the last few decades, which has important implications for valuation.

The most important trend in finance? 

Source: 10-Year Treasury Constant Maturity Rate, Federal Reserve Bank of St. Louis, 13/01/2021

 

Since the early 1980s interest rates have steadily been falling. Inflation has been low and fairly stable for a while now, so inflation adjusted (real) interest rates have also fallen precipitously and this trend has profound implications for investors.

Primarily, this is because of the Time Value of Money. All else being equal, a lower interest rate makes stocks more valuable. Stocks are not necessarily more “expensive” just because CAPE ratios are higher now than in the past. They are simply worth more than they used to be.

This means long run comparisons of CAPE or PE ratios can be misleading when we’re trying to assess the overall valuation of the stock market. Fortunately, there is another way to try and gauge the value of the stock market.

Bubble is the wrong idea 

Long run CAPE or PE comparisons may be a misleading tool when trying to assess stock market valuations because interest rates vary over time and are a key determinate of asset values.

As interest rates have fallen over the last few decades, we should expect stock markets to trade at a higher level. To test this theory we can look at other valuation measures, and when we do the market doesn’t look overvalued.

This doesn’t mean individual companies aren’t over or under valued though, some may well be. And this is a risk investors should consider on a case-by-case basis.  It’s also not to say stock markets can’t fall from here. They definitely could. Earnings growth could fail to live up to expectations, or expectations of future earnings could change. If so, the market would fall. Similarly, if interest rates rose the same process explained above would play out in reverse, and the market is likely to fall dramatically, all else being equal.  However, shares aren’t necessarily overvalued just because there are risks. An overvalued investment is one that will struggle to deliver returns that appropriately compensate for the risk taken even if all goes well.”

Today’s Most Read

IFA Magazine

Keep updated on the most important financial events 

Make sure you are an informed

wealth professional..

Adblock Blocker

We have detected that you are using

adblocking plugin in your browser. 

IFA Magazine