The New Bubble


"If you're in the market, you have to know there's going to be declines."


- Peter Lynch


Since 1950, the S&P 500 index, which tracks the performance of 500 large, public companies listed in the United States, has been fairly valued or undervalued for most of the 70 years. These valuations allow for steady returns and a reliable market with minimal levels of volatility.


However, there have been two instances in this 70-year period where the S&P 500 has been extremely overvalued – the dot-com bubble in the late 90s and right now. This is not to say that the market is going to react in a similar manner to the crash of the dot-com bubble, but it is safe to say that the current market, as a whole, is overvalued.


These high market valuations can be seen in the two graphs above, both of which are concerning in their own regard. The price-to-earnings ratio, or PE ratio, divides a stock’s share price by its earnings per share, showing relative valuation through the multiple of earnings that the market is willing to pay for a share of stock.


The first graph shows the S&P 500’s PE ratio since 1950 compared to its average. As previously referenced, the present and the dot-com bubble are the two times over this period where the market has been overvalued by two standard deviations of the PE ratio. The current market is well beyond the dotted line which represents the average PE since 1950. In the dot-com bubble the S&P 500 fell by almost 50%, showing the need for investors to be wary with valuations nearing previous highs.


In the second graph, the Shiller PE ratio is used. This form of the ratio is similar to the original, but it is averaged out over ten years and adjusted to inflation for more accuracy. Here it can be seen across the 150 years shown by the graph that the market is at its second-highest valuation, only behind that of the dot-com bubble. Any time this ratio has been above a value of 30, there has been a market crash – the Great Depression and the dot-com crash. The market currently sits at a value of 34.81 and, if history repeats itself as it tends to do, investors should brace themselves for rough market conditions. Low interest rates enable the market to stay at these valuations without crashing, but when they end up rising, it could be detrimental.

From the recent years of near-zero interest rates, low bond yields, and a large influx of federal spending into the hands of investors, it can be seen why the stock market has seen such an attractive investment. The historical returns realized over this period have also caused many to oversee the current burdens on the market. Strong inflationary pressures, record gas prices, 20-year highs in S&P 500 valuations, and the conflict between Russia and Ukraine are all weighing down investor sentiment.


Domestically, the largest area of concern is inflation, which can ruin a country’s economy if not properly contained. The Fed already announced its plans to implement contractionary monetary policy, which reduces the money supply through increased interest rates and decreased bond prices. With inflation surging, there is really no alternative to the Fed raising rates, which has the possibility of sparking a surge of selling in equity markets.

Rising rates are unattractive to businesses because it increases the price of borrowing money, leading to higher costs for companies to finance their operations. These costs usually result in lower profits due to the added expenses in borrowing. Moreover, most companies use a large amount of debt in their capital structure to finance their business and invest in growth. This happens because it is hard for companies to fund these activities with the limited amount of cash usually held on hand. Therefore, a hike in interest rates affects almost every business, public and private, by increasing their borrowing costs. The repercussions typically lead to a slowdown in overall economic growth as a result.

Considering the current overvaluations in the stock market, which signal investors expect a large amount of growth in the coming years, a rise in interest rates could serve to be a negative catalyst for stocks. Higher rates prompt people to invest in new bonds and to hold more money in savings accounts, driving capital away from overvalued stocks. Although, during a time of rising rates, the bond market also has the ability to hurt investors, dependent upon which bonds they invest in. Similarly, there will still be an opportunity to profit in equity markets, but the stellar returns seen by most companies from mid-2020 until late 2021 should not be widely expected.


To illustrate the scenario, the current market environment is comparable to an overinflated bike tire. The tire, representing the stock market with high valuations, can still be used, but it will not be as smooth of a ride as with a perfectly inflated tire. Some of that air must come out of the tire for it to sustainably function, representing money leaving the stock market, bringing companies back to fair valuations. The air from the tire does not just disappear, it goes back into the environment and the air we breathe. Similarly, the money from the stock market would be reinvested into bonds, savings accounts, and other low-risk investments.

Alternatively, if rates stay where they are, this is a healthy stock market. However, nobody knows where rates are going, and it is difficult to predict the stock market’s performance. With the current pace of inflation and the sentiment of the Fed, it is likely rates will rise. The amount by which they rise will make or break the overall markets, but it will be hard to stop the surging inflation and please equity investors at the same time.


In these times, being a blind investor in indices may lead to the inability to produce returns for years. During the dot-com bubble, which is the last time S&P 500 valuations were as high as they are now, it took eight years for the market to achieve its previous highs again. In this new bubble, there are still an abundance of possibilities for investment and profit in the markets. The next newsletter will detail how to mitigate risk and safely generate returns in a stock market that is overvalued.


By: Siddharth Singhai

Disclaimer


Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.