The U.S. stock market performed very well during 2013. The S&P 500’s total return of nearly 33% far outpaced the returns of most asset classes. Interestingly, the rally in U.S. stocks occurred despite a significant increase in longer-term interest rates. The 10-year Treasury note hit a low of 1.6% in early May and rose above 3% by year-end.
We continue to believe that much of the bull market has followed historical precedent despite the unusual magnitude of the monetary and fiscal policy catalysts used in an attempt to right the economy. Whereas some investors have suggested the stock market should not be rising in combination with rising rates, 2013’s performance seems to us to be a normal mid-cycle rally in which the unanticipated improvement in fundamentals typically outweighs the negative effects of rising rates.
A growing contingent of market observers is fearful that the U.S. equity market is in some sort of a bubble. We disagree completely with this notion. A strong market rally that many investors have missed is hardly sufficient grounds for a financial bubble.
High beta stocks are undervalued
It seems to us that a necessary condition for an equity bubble is the overvaluation of the stocks most sensitive to the overall stock market’s movement. It seems very unrealistic that high beta stocks could be selling at historically conservative valuations if there really was an equity bubble underway.
Chart 1 shows the relative valuation of the stocks in the S&P 500 with the highest betas (i.e., those stocks with the highest sensitivity to overall market movements) versus those with the lowest betas (i.e., those with the lowest sensitivity). Despite claims that the equity market is in a bubble, it is low-beta stocks and not high-beta stocks that are selling at rich valuations. High-beta stocks are actually close to record conservative relative valuations.
What constitutes a bubble?
In his wonderful book, “Devil Take the Hind Most,” Edward Chancellor demonstrates that financial bubbles tend to follow similar patterns. Most important, his work suggests that valuation alone does not constitute a financial bubble. Financial bubbles go beyond the financial markets and tend to pervade society.
Our interpretation of Chancellor’s work is that there are five common characteristics to a financial bubble. The U.S. equity market does not seem to match these characteristics. The five characteristics are:
- Available liquidity
- Increased use of leverage
- Democratization of the market
- Increased turnover
- Record new issues
One could certainly argue that the Fed’s extraordinary efforts to stimulate the U.S. economy have provided tremendous liquidity to the financial markets. However, we find scant evidence that the other four characteristics currently apply to the U.S. equity market. For example, many have noted that volume was weak during 2013, new issues were not rampant and protection was more important to most investors than using leverage to accentuate performance.
But, isn’t the market’s P/E ratio very high?
The absolute valuation of U.S. equities is not cheap. However, the market appears fairly valued if one accounts for interest rates or inflation. After all, shouldn’t the P/E ratio be relatively high when inflation is less than 2%?
Chart 2 below shows the 12-month forward returns of the S&P 500 using combinations of valuation (defined using the often-discussed Shiller “CAPE” Cyclically Adjusted P/E ratio) and inflation. Although historical comparisons to the current environment don’t suggest extremely high returns for the S&P 500, it does suggest roughly “normal” returns.
P/E-driven versus earnings-driven bull markets
Investors seem to be assuming that every bull market starts with a low P/E and ends with a high P/E. However, history shows that has not always been the case. There have actually been two types of bull markets. Some have been P/E-driven, meaning that interest rates fall and P/E multiples expand. Most of the bull markets after 1980 fit this description. Other bull markets have been earnings-driven, meaning that interest rates rise and P/Es contract, but earnings growth is strong enough to more than offset the negative effects of rising rates and P/E compression. 2003’s bull market would be an example.
Skepticism doesn’t accompany bubbles
While there is no doubt that investors’ fears regarding equities after the 2008 bear market have started to subside, this is a normal occurrence for a mid-cycle environment. The euphoria that is typically present at market peaks has yet to occur.
There are indeed financial bubbles around the world. Credit growth in China would be a perfect example. However, we strongly doubt that U.S. equities should be added to that list.
The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indexes. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website.
Past performance of an index is no guarantee of future results.
Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indexes are not actively managed and investors cannot invest directly in the indexes.
S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.
Inflation: Consumer Price Index (CPI). The CPI is a measure of the average change in prices over time of goods and services purchased by households. It is based on prices of food, clothing, shelter and fuels, transportation fares, charges for doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living. Source: Bureau of Labor Statistics (BLS).
In our Shiller CAPE (Cyclically Adjusted P/E), Inflation and Subsequent 12-month S&P Returns study, we have used the Robert Shiller CAPE and Inflation data series as published on his website (www.econ.yale.edu/~shiller/data.htm). For our S&P Composite Returns calculations, we have used the S&P Composite data series from the Online Data Robert Shiller website for the data prior to 1926. From 1926 on, we have used the Ibbotson Large Company Stock Total Returns. The Ibbotson Large Company Stock Index represents the S&P 500 from 1957 on. Prior to 1957 it consisted of 90 of the largest stocks in the U.S.
Equity investing is subject to stock market volatility. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, established companies. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging or frontier countries, these risks may be more significant. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, established companies. Investing involves risks including possible loss of principal.
Investing is an inherently risky activity, and investors must always be prepared to potentially lose some or all of an investment’s value. Past performance is, of course, no guarantee of future results.
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