Are we in a global stock market bubble?

It’s been almost a year since the global pandemic hit and stock markets around the world dropped. As we’ve adjusted to a new way of life and the rollout of vaccines has started, there seems to be light at the end of the tunnel.

With the positive news, we’ve seen stock markets around the world pick back up. But could the rise in share prices be too good to be true? Experts have started to wonder whether we could be in a bubble – one that could eventually burst.

This article isn’t personal advice. All investments can rise as well as fall in value so you could get back less than you invest. If you’re not sure if an investment is right for you, then please ask for advice.

What’s a stock market bubble?

A bubble is where the price of an asset, like a share, dramatically rises over a short span of time. Soon enough the price at which the asset is trading no longer reflects what it should actually be worth. As more people rush to buy it the price goes up and up and eventually drops, causing the bubble to burst. This sudden drop is called a “correction”.

So why now?

Global markets have risen to record highs since last March, with the value of some technology stocks being particularly high.

With rising stock markets, the feeling of euphoria can quickly set in. After all, who would want to miss out on investing in a rising market? But there can be problems when investors start jumping in for the wrong reasons. Some parts of the stock market can quickly become overvalued.

In fact, expert investor at GMO Jeremy Grantham has described the recent rally and rebound of global markets as an “epic bubble” plagued by “overvaluation”.

While there’s good reason to be wary of the recent market rises, perhaps we shouldn’t be so quick to jump to the idea we’re in a stock market bubble. There are a few factors that suggest valuations could be at reasonable levels.

Inflation and low interest rates

Interest rates are currently close to zero. The US Fed rate is at 0.25%, and the Bank of England base rate (the UK’s central bank) is 0.1%. There’s also speculation that the huge economic stimulus packages from governments and central banks around the world could kick start inflation.

How should investors respond to a change in inflation?

Inflation and interest rates help determine the time value of money. If interest rates stay low, and inflation rises, a pound today is worth more than a pound tomorrow. But if interest rates are higher than inflation, a pound today could be worth less than a pound tomorrow.

So why are inflation and low interest rates important to valuation?

One of the ways to value a company is to estimate the future cash flows it’ll generate and how much future cash flows might be worth.

To do this future cash is discounted by the interest rate, and with low interest rates, future money is worth more compared with higher interest rates.

Effect of interest rates on future value of cash

Interest rates could stay low. Governments and central banks will want to stimulate spending, and to kickstart economies in the recovery from the pandemic. Drastic increases in interest rates would hurt that effort. So with this in mind, the valuation of companies might not be that overblown.

The Cyclically Adjusted Price-Earnings (CAPE) ratio

Talk about stock market bubbles usually revolves around price/earnings (PE) ratios that have been cyclically adjusted.

A CAPE ratio divides the share price of a company by the average of its inflation adjusted earnings in the last ten years. It gives us a company’s valuation, while considering the influence of natural booms and downturns in the economy.

What the CAPE ratio doesn’t account for is the structural changes in an economy that might take place in a decade. Businesses that are successful today could have generated more, or less, earnings than they did 10 years ago. For example, the profits banks make have been cut by low interest rates, which could continue. Technology businesses on the other hand play an ever-increasing role in the global economy.

Disruption and persistent performers

Talk on stock market bubbles doesn’t tend to take into consideration the disruption to industries and sectors over the past year. Some of the biggest companies to have benefited from the disruption are ones that are well equipped for stay-at-home orders and facilitate working from home.

Zoom, Spotify, Peloton, and Ocado are just some examples of companies whose share price rose as their value became realised in the new work-from-home economy.

The digitisation of our daily lives has highlighted the ever-increasing importance of technology, which allowed these businesses to drive the recent growth in valuations. It’s the reason why companies like Microsoft grew their revenue by 14% in such an unprecedented year (source: Bloomberg, 31/12/19 to 31/12/20).

These trends are likely to carry on as we continue to adjust to the ‘new normal’. It’s something other companies will also need to think about in order to survive.

It’s important to remember though, past performance isn’t a guide to the future. We don’t know what’s around the corner, so there’s no guarantee of success.

So, what does it all mean?

Ultimately, if shares are overvalued, what suitable alternatives are out there for long-term growth? With interest rates being so low, the returns available from bonds and cash savings will continue to stay low for the time being.

Even if share prices are in a bubble now, markets have historically recovered after corrections and crashes. Investors who ride the ups and downs have usually benefited in the long run.

That’s how we run our HL Select funds. We don’t trade businesses – we own them with a long-term view for growth.

Thinking like a business owner – investing tips from an HL fund manager

The HL Select funds are run by our sister company HL Fund Managers Ltd.

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