Is the US stock market in a bubble?

As we’ve entered the start of the new year, the US stock market has continued to climb to record heights. Veteran investor Jeremy Grantham has gone as far as to say we’ve reached “a fully-fledged epic bubble.”

The market is, in some ways, highly rated if we compare it to its history. And there’s a fair amount of excitement around some companies and sectors. But that doesn’t necessarily mean we’re in a bubble.

Instead, the decline in interest rates since the 1980s could both explain and justify the market’s higher rating. And this could also be part of the reason the US market has performed so well since the Financial Crisis.

Even if the US stock market isn’t in a bubble, there are still risks. All share prices can fall as well as rise, and this article isn’t personal advice.

Why do some people think we’re in a bubble?

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

1. Stocks have had a good run for a little over a decade now. Since just after the Financial Crisis, the US stock market has returned 560% including dividends (source: Refinitiv Datastream, 1/3/09 to 14/1/21).
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. An over-optimistic view of the US stock market from investors.

Bubbles make people nervous because they have a habit of bursting. You do need to look at the risks carefully though. Remember, it’s important to hold a diversified portfolio and past performance isn’t a guide to the future.

The Cyclically Adjusted Price Earnings (CAPE) Ratio

A normal price/earnings (PE) ratio is an investment’s price divided by its earnings or profits. In this case, we’re looking at the S&P 500. If company profits vary from year to year, a PE ratio can be misleading as profits could be unusually and unsustainably high or low.

For example, profits at lots of companies were a lot lower in 2020 because of the coronavirus pandemic. A PE ratio could be misleading if investors expect those profits to recover.

Nobel Laureate Robert Shiller instead divides the price of the index by the average of its earnings in the last ten years, all adjusted for inflation. That way, 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. It’s also known as a Shiller PE ratio.

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

CAPE Ratio for S&P 500

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

This shows the US stock market has only been this highly valued twice before. This was 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 by a lot in the last few decades, which has important implications for valuation.

The time value of money

Falling interest rates increase investment values, all things being equal.

To see why, imagine how much money you would need to put in the bank to get £100 back in 10 years at different interest rates.

If interest rates are 1% and you put £90.53 in the bank and wait 10 years, you’d have £100. So when interest rates are 1% you should be indifferent between £90.53 today, and a guarantee of £100 in 10 years. But, when interest rates are 10%, you’d only need to put £38.55 in the bank to get £100 back in 10 years.

A guarantee of £100 in 10 years should be worth a lot less to you when interest rates are higher, and a lot more when interest rates are lower. That’s because when interest rates are lower, you’d have to put in a lot more to get the £100.

This idea is known as the time value of money.

When you buy stocks, you’re essentially spending money now to try to get back more money in the future, usually through dividend payments. How much those future dividends are worth depends a lot on interest rates.

But why does this matter now?

The most important trend in finance?

10 Year Treasury Yield

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

Since the early 1980s interest rates have generally been falling. Inflation has been low and quite stable for a while now, so inflation adjusted (real) interest rates have also fallen.

This has important implications for investing because of the time value of money we’ve mentioned. A lower interest rate should make stocks more valuable.

Stocks aren’t necessarily more “expensive” just because CAPE ratios are higher now than in the past. They’re just worth more than they used to be.

Comparing CAPE or PE ratios over the long term can be misleading when we’re looking at the overall valuation of the stock market. Fortunately, there is another way to try and gauge its value.

The equity risk premium

Investors always have the option of investing their money in government bonds. Their risk is usually lower than other investments, so analysts use them to estimate a risk-free return. If investors are going to put their money into something riskier, like equities (shares to you and me), they’ll usually want to make a higher return.

Investors call this additional return the equity risk premium.

return on stocks = risk free rate + equity risk premium

Over the last few decades, the risk-free part of this equation has fallen, which you can see in the above graph of long term US government bond yields. But what’s happened to the equity risk premium?

When stocks are “expensive” the return investors expect, or the equity risk premium, will be lower. And when stocks are “cheap” the premium will be high.

Aswath Damodaran, Professor of Finance at New York University, estimates an implied equity risk premium for the US market each year. He uses estimates of short-term earnings growth, government bond yields, and the market level to do this.

This approach lets us estimate the equity risk premium investors are demanding given expectations about future growth. There is no guarantee though that the market will deliver this extra return, especially if expectations end up incorrect.

Implied Equity Risk Premium

Source: Aswath Damodaran, 14/01/21

During the Dot Com bubble in the late 1990s, the equity risk premium was very low. If we compare that to when the stock market crashed during the Financial Crisis at the end of 2008, it was relatively high.

If we were in a bubble, or stocks were “expensive”, we would expect the premium to be a lot lower than it is now. Instead, the premium is still at quite a healthy level compared to its history. If future earnings growth turns out to be much lower than expected, then stocks are of course unlikely to generate this premium. However, given market expectations this data doesn’t suggest the market is “overvalued”.

Robert Shiller has also updated his CAPE index to reflect changes in interest rates. In a recent article he wrote “despite the risks and the high CAPE ratios, stock-market valuations may not be as absurd as some people think”.

Bubble is the wrong idea

When we compare CAPE or PE over the long term, what we see might be misleading. Interest rates vary over time and are key to determining the value of investments.

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 undervalued though, some might well be. And this is a risk investors should think about on a case-by-case basis.

It’s also not to say stock markets can’t fall from here. They definitely could.

Companies might not grow as fast as people think, or expectations of how much money they’ll make in the future could change. If so, the market would fall. Similarly, if interest rates rose the market is also likely to fall.

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.

What can investors do?

Ultimately, you need to decide how much risk you’re willing to take. Everyone’s situation will be different, and risks that make sense for one investor might not be right for another.

Remember, you don’t need to put all your money into stocks and should always hold a diverse portfolio. If you’re unsure, think about seeking professional advice.

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