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Is there a US stock market bubble?

7 signs trouble is brewing.

December 9, 2015

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story_images_bubblesValue investors are “economy agnostics”. They are bottom up long-term fundamental analysts trying to buy stocks cheap with little consideration of what the economy will do. The credit crisis of 2008, however, changed many value investors’ view of the macro picture. They have come to realize that while the stocks they buy can be cheap, they can become even cheaper if the whole market is overvalued.

The motto for many value investors now is “worry top down, invest bottom up”. An example of an investor who adheres to this approach of value investing is Prem Watsa of Fairfax Financial Holdings. He likes to buy cheap but when he feels the market is overvalued, as he believes it is the case now, he likes to hedge the macro risks using derivatives, such as index put options, credit default swamps, and so on.

But is the market overvalued right now? Or worse, is there a stock market bubble?

It is possible: artificially low interest rates can create bubbles.

Warning signs

Here are some ominous signs according to data sourced from Germany’s DZ Bank. US companies have steadily increased their debt exposure over the last 15 years from about 175% of GDP to around 240% recently. Low interest rates have encouraged companies to raise debt to support mergers and acquisitions or for share buy backs. The market for M&A activity will hit a new record this year given that up to October there were deals completed worth $2.2 trillion. The previous cyclical peak was in 2007 when deals worth $2 trillion were completed. Similarly, companies spent $650 billion this year in share buy backs, a new record exceeding the previous record of $566 billion reached in 2007.

How about some popular metrics of market valuation?

First, the ratio of Wilshire Total Market Index to US GDP, Warren Buffett’s favorite, shows that the market is overvalued by 44%. The ratio currently stands at 119% vs. a historical average of 82.5%.

Second, the relative valuation of the equity market in relation to the bond market shows that the stock market is undervalued in relation to the bond market by 22%. The earnings yield (the inverse of the PE ratio) exceeds the bond yield by 360 basis points. The long term average is 280 basis points.

Third, the price to forward earnings ratio shows that the market is overvalued by 8%. This ratio currently stands at 16.8 times vs. its historical average of 15.5%.

Fourth, the cyclically adjusted price to earnings ratio (CAPE) that Nobel Prize winner Bob Shiller has developed, which uses the 10-year smoothed, inflation-adjusted earnings, shows that the market is overvalued by 52%. The ratio currently stands at 25.2 times vs. a historic average of 16.6 times.

Fifth, the price-to-book value ratio shows that the market is overvalued by 17%. This ratio currently stands at 2.8 times vs a historical average of 2.4 times. If we exclude financials this ratio stands at 3.4% vs a historical average of 2.7 times, making the market overvalued by 26%.

Sixth, the price-to-cash flow ratio shows that the market is overvalued by 6%. This ratio stands at 12.5 times vs a historical average of 11.8% since 2000.

Finally, the ratio of annual forward dividend to price (dividend yield) shows that the market is overvalued by 48%. This metric currently stands at 2.10% vs a historical average of 3.1%.

The above metrics indicate the US stock market is overvalued by between 6% and 52%. Only one metric indicates undervaluation, but this measure is biased by the prevailing artificially low bond yields.

So is the market in bubble territory?

To answer this question, one needs to understand the drivers of the above ratios, which are interest rates and/or earnings growth. For example, the CAPE of 25.2, which indicates the most market overvaluation, is not terribly high given the current interest rate and economic environment, and hence is not pointing to overvaluation. This is assuming the earnings growth rate going forward is 7.2 percent (i.e., comparable to its long-term historical average of 7.41 percent) and interest rates remain at the current all-time low levels.

If, on the other hand, an investor believes that we are heading into a future of higher interest rates and/or lower earnings growth, then CAPE is indeed signaling overvaluation and quite possibly a bubble.

In this context, there are two facts to consider.

First, corporate profits benefited in the past seven years because of declining commodity prices and a weak jobs market that drove down the cost of labor. But now US companies face the risk of an “earnings recession” for the first time since 2008. The strong US dollar and the collapse of oil prices are partly to blame. The tightening of the labor market, however, is compounding the threat on profit margins. As reported by Bloomberg Businessweek, there are now 1.5 unemployed job seekers for every opening vs. 6.8 in 2009. Wage growth, as a result, is currently running at about 3% vs. an average of about 2% over the last five years.

Second, the current environment of rock bottom interest rates leads to the conclusion that there is an increased chance of higher interest rates in the future.

Normally, it is difficult to determine whether a bubble exists until it is too late — but even if we know we are in a bubble, it is difficult to foresee when it will burst. As a result, stay invested if you wish, but do what a value investor like Prem Watsa would do, namely, hedge the macro risk using, for example, long-dated index put options.

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