US markets are making new highs and the CAPE valuation ratio has passed 35 times, the highest level since 2001. I argued in a blog in December that low yields justify high stock valuations up to a point and I will return to this issue in a future post. Today I look at the bubbly behaviour in the US market and ask how much we should worry.
You can’t identify a bubble with valuations alone because sometimes high values may be justified. That’s why I have long used a checklist which also includes a variety of behavioural and general economic factors. The current situation ticks most of the boxes on the checklist suggesting that, at the least, things are getting bubbly.
At this point I should emphasise strongly that this does not mean I expect stocks to collapse tomorrow. In fact, even if we called it a bubble (which I don’t), bubbles usually go on far longer and inflate far further than seems likely. Calling it a bubble would only mean it may be time to consider rebalancing, or look for areas that have been left behind.
Down the checklist
Going through the checklist, obviously one or two don't apply currently. We are not several years into a business cycle (5) which is when investors usually get over-confident, nor is the US dollar strong (15). It is not weak either though it has been weakening. And while the household savings rate is falling (14), it is coming down from an extreme high last Spring caused by the Covid shock so is not playing its usual role in this checklist of signalling high confidence and low fear.
But we are seeing most of the items on my checklist. The new 'rationale' (6) for high valuations is that tech stocks are benefitting as people switch to working and shopping from home. The new paradigm (7) is the low yield environment. Both the rationale and the new paradigm are valid and rational. But bubbles nearly always start from rational optimism. For example, the British ‘railway mania’ of 1846 correctly anticipated that railways would be a transforming technology. That didn’t stop the rampant speculation ending in a stock price bust.
New investors have been drawn in (8) as young people use the new commission-free brokers like Robinhood. There are also new entrepreneurs in the technology and green areas (9). Option trading in recent weeks has been running at double 2018 levels (12). There has also been plenty of media interest (10).
So what does bubbly behaviour mean?
The market is bubbly. Does this make it a bubble? Well, not if we accept the current level of valuations as justified by low yields. US 10-year TIPs yields are -1.05% but were positive at the end of 2019. Lower real yields justifies higher valuations than a year ago (assuming a positive outlook for defeating Covid). However the bubbly behaviour listed above does suggest treating investing in the market cautiously, especially when the bubbles focus in a particular sector (I’m thinking cryptocurrencies or tech stocks, especially the ones not making profits). It is also worth noting that European and UK stocks are much less bubbly and also on much lower valuations, suggesting that they may offer better long-term prospects.
John Calverley, Chief Economist