Does the massive run-up in stocks have you concerned? It’s OK to nod your head.
The fact is that many people are worried as we head into the 2021 holiday season. The MSCI ACWI index, which measures the global equity market, has almost doubled since March 2020 (Exhibit 1). This has some investors (and TV pundits) exclaiming that the stocks are officially in a bubble. Fear-mongers often look at trailing returns in isolation — then declare them to be proof of the adage, “what goes up, must come down.” Here at SYM Financial, we prefer to look at the weight of the evidence instead of picking and choosing the scariest-looking charts. To be fair, there are plenty of those available… So, let’s start at the beginning. SYM’s Chief Investment Officer Andy Popenfoose shares his insights.
Exhibit 1: MSCI ACWI Global Stock Market Index Performance Since the COVID-19 Low[i]
What Makes a Bubble?
A stock market bubble, as it is defined, is when share prices rise exponentially over a period of time to a level that is well in excess of intrinsic value.[ii] In other words, a bubble happens when prices far exceed the fair market value. Another characteristic of a bubble is extremes in optimism and emotional exuberance.
In a bubble environment, investors orient on the short term and buy assets simply to sell them for a higher price to a greater fool. A great example of this is Extraordinary Popular Delusions and the Madness of Crowds (Mackay 1841). This text (admittedly old, and yet highly relevant because human nature has not changed) describes extremes of sentiment and apparent mass irrationality leading to periods of panic buying and selling. In such environments, asset prices detach from economic fundamentals.[iii]
Are Today’s Asset Prices in Bubble Territory?
To put it another way, have stock prices (and other security prices) drifted too far from economic reality? Are businesses today worth significantly more than they were two years ago?
We would argue that asset values indeed are higher today.
This may be an unconventional opinion, so let us step back in time 20 months or so to revisit the most fearful times of COVID-19.
What were some of the major risks across global stock markets? Elevated inflation, supply chain disruptions, and labor shortages were not in the news. Pressing on the minds of investors and executives alike was bankruptcy risk. Governments were shutting down entire economies. There was fear that a vaccine would take years to develop and distribute, and that the damage to the economy would be irreversible.
Would families be unable to pay their mortgages? Would renters be evicted? What would the government’s response be? What’s going to happen with schools? How much stimulus would it take to save the economy? How badly would the labor market be crushed by businesses and corporations slashing costs just to stay solvent? It was perhaps the most fearful few weeks since the Great Depression.
Two Years Later, Concerns Look Different
What are business and economic conditions now?
Key measures such as retail sales and employment surveys are booming. So too are the readings from various Purchasing Manufacturers Indexes (PMIs) and Leading Economic Indicators (LEIs). Just recently, the IHS Markit Flash U.S. Composite PMI was 57.3 for October, indicating robust economic growth (Exhibit 2).
Also in October, The Conference Board released its LEI data showing continued expansion despite third-quarter issues including the Delta variant, rising inflation, and supply chain disruptions.[iv] Rising leading economic indicators typically precede economic growth.
Exhibit 2: Economic Growth Continues Running Strong[v]
More good news: Corporate earnings have never been better, according to the latest round of third-quarter results. Companies are doing more with less. Profit margins are strong as many employees work from home.
Meanwhile, the unemployment rate is nearing pre-pandemic levels, and there are a record number of job openings.
And how did the fear of mass bankruptcies fare? Surprisingly benign. Even within the less credit-worthy “high yield” category of speculative corporate bond issuers, Fitch projects 2021 default rates to reach 10-year lows.[vi] 2020’s business failures seem not to have been as widespread as many worried.
Putting It All Together
In our opinion, the current scenario in the markets does not exhibit the characteristics of a bubble.
It is simply not apparent that stock prices decoupled from the economic reality. Despite a significantly higher stock market today versus March of 2020, we believe strong economic growth and record corporate earnings warrant meaningfully higher stock prices than those witnessed in the Covid-19 bear market.
What about the future?
It is unreasonable to expect equities to continue to surge higher at the same pace as we have witnessed in the last 20 months. While we are likely not in a bubble, that does not mean stocks cannot correct (or even fall into a bear market). But to say that the global markets are in a bubble is simply a doomsday prediction with little merit to support that argument. Those who are pounding the desk with that narrative are only looking at prices — not at the economic fundamentals or intrinsic values of companies.
SYM Financial Approach: Don’t Fear the Bubble
Our team has incorporated the elevated stock valuations into our clients’ planning outlooks over a long time horizon. We assume positive, but below average, future equity market returns at this time. As our earlier points hopefully drive home to readers, our conservative return forecast is far different from a bubble warning. Our approach recognizes that financial markets go through periods of booms and busts. However, it is extremely rare for a boom to be so irrationally exuberant as to qualify as being a bubble. Our clients can expect the SYM team to ground them in their goals — and to examine well-rounded evidence to guide their investing decisions, today and into the future.
[iii] CFA Program Curriculum 2020 Level III, Volumes 1 – 6