Monday, November 25, 2013

A Stock Market Bubble?

There has been a lot of talk of a stock bubble in the financial media. One of the cover story for the weekly Barron's magazine was "Bubble Trouble?" (subscription required to read). Also, there was another good WSJ story that used Robert Shiller's favoured Cyclical Adjusted P/E (CAPE) ratio to argue stock valuations are getting frothy. The CAPE, which divides the S&P500 price by a 10-year average real earnings number,  is near 25.1 compared to the 130 year average of 16.  With the S&P500 rallying over 27% this year, NASDAQ over 30% and Dow Jones Industrial 22%, it definitely looks like a stock market bubble is building. However, I should caution investors not to call a top based on the YTD performance or the fact that the S&P500 is up over 170% since its low in March, 2009. 

The Frothy Side:

Let's not forget the cause of the market rally this year. The key reason is that low interest rates, caused by ultra loose monetary policies like QE, pushed many investors up the risk curve. Some fixed income yields, namely short term treasuries, were negative after adjusting for inflation (real yield) which forced investors to seek higher yielding assets in either corporate bonds, high yields or even conservative blue chip stocks. The key measure that determined whether investors prefer bonds or stocks is spread between the earnings yield (E/P or inverse of the P/E ratio) and the bond yield. At the start of the year, the 10-year US  treasury yield was near 1.8% and the S&P500 earnings yield was 7.5% or almost 4 times higher! It's a no-brainer why stocks rallied. The fact pension funds and mutual funds had low equity exposure also fueled the equity rally as those "big players" re-entered the market. 

Despite a small correction in the summer due to the taper tantrum, stocks kept on rallying. The current earnings yield of the S&P500 is about 6% while the 10-year US treasury is yielding near 3%, which reduced the attractiveness of stocks by 50%. The S&P500 is trading at 16.5X trailing earnings and 15.1X forward earnings. Those measures are slightly higher than historical averages but well short of the P/E north of 20X in the dotcom boom and 17-18X at the height of the 2007 bull market. This means that stocks can still rally further. Mutual fund asset levels are still low compare to 2007 and many pension funds are still under-weighing equities. Therefore, don't be surprised if stocks move higher. 

However, what worries me is that the equity rally is mostly due to P/E multiple expansion. Recall changes in price is the product of changes in earnings multiplied by changes in the P/E ratio. Given the aggregate S&P500 earnings is foretasted to increase only 6% in 2013, the 27% rally in the index was caused mostly by a 20% expansion in the P/E ratio. P/E doesn't expand forever and the fact earnings growth is unlikely to pick up is a cause for concern. 


The Problem of Calling a Top: 


In December 1996, former Fed Chair Alan Greenspan made his famous "irrational exuberance" speech questioning the valuation of equities at that time. Some investors agreed with Greenspan and started shorting equities. The fact the stock market advanced 31% in 1997, 26% in 1998, and 20% in 1999 proved many of those skeptics wrong. The point I want to make here is that calling a top is extremely hard. Many should not even waste the time or effort to because it is hard to get both the timing and thesis correct. 


So, What to Do? 

Bonds are still yielding close to nothing (after adjusting for inflation) while stocks may be in bubble territory. My opinion is that stocks should be preferred to bonds.

Reasons:  

  • Earnings yield of 6% is still 2 times higher than long term treasury yield and higher than most fixed income yields (including junk bonds that are yielding near 5%) 
  • Stocks provide investors with great long term performance despite short term troubles. Let's not forget that in the 20th century, the Dow Jones returned 5.1% compounded annually. For those who are not aware, the market experienced several large drops greater than 50% with the Dow losing 90% from 1929-1933. That period also included 2 World Wars, the Great Depression, a Cold War, a decade of super high inflation etc. 
For the average Joe investor, a bubbly market should not deter them from a conservative dollar cost averaging strategy where one sets aside a fixed amount to put into an index fund every month or quarter. For more active investors, there are still bargain stocks available especially in the mining space. Trying to call a market top is foolish because no one has a perfect crystal ball. Investors should adhere to strict investment rules such as buying stocks at reasonable valuations (i.e. significantly below intrinsic value) in order to provide them with a margin of safety. Timing the market appears to be simple and easiest strategy to make money but its application is hard in practice. 

In short, although I worry about a stock market bubble, I'm still long stocks in my portfolio because they still provide the best risk-adjusted potential return. I use the margin of safety principle advocated by Ben Graham to help protect my downside by buying stocks with low valuations, healthy balance sheets and high future earnings power. I tried calling market tops and bottoms in the past but learned it's better to admit you can't. Many times, you get the thesis right, but the wrong timing can kill you. As Keynes famously said: "The market can stay irrational longer than you can solvent". 



2 comments:

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