We don’t think that there is a bubble in the US stock market. Yet even if we are wrong, it may inflate further before bursting given the outlook for the economy and monetary policy.
- We don’t think that there is a bubble in the US stock market. Yet even if we are wrong, it may inflate further before bursting given the outlook for the economy and monetary policy.
- To re-cap, one widely watched gauge of the US stock market’s valuation is Shiller’s cyclically adjusted price/earnings ratio (CAPE) for the S&P 500/Composite. This measure attempts to strip out the “noise” of the business cycle by using an inflation-adjusted average of earnings in the past decade in its denominator.
- Shiller’s CAPE has risen to ~34.8 at the time of writing, above its peak in September 1929 of ~32.6 before the Great Crash. Indeed, the only time it has ever been higher since the start of Shiller’s time series for the metric in 1881 was during the dot com bubble at the turn of the 20th century – the peak in December 1999 was ~44.2. For context, the (harmonic) average of the ratio since 1881 is only ~14.5. Not surprisingly, the current level of the CAPE has therefore led to claims that the stock market is now in another bubble.
- We are not convinced, for three main reasons. First, we are wary of inferring from the recent big increases in the prices of some equities that the entire stock market is highly overvalued. Second, we think that the sustainable valuation of the market today is higher than its long-run average because the sustainable levels of “risk-free” rates are lower now than their long-run averages. And third, we cannot yet see the kind of leverage or financial imbalances that have typically accompanied bubbles in the past. (See here.)
- The current buoyancy of equity prices seems to reflect a view, which we share, that we are set for a long period of very loose monetary policy despite a strong recovery in the economy after COVID-19. If that view doesn’t alter, we suspect that the valuation of the stock market will continue to rise rather than fall.
- After all, at ~3.5pp, the gap between Shiller’s cyclically adjusted earnings yield (CAEY) – i.e. the reciprocal of his CAPE – and the real yield of long-dated Treasuries remains fairly large, unlike on the eve of the Great Crash or the bursting of the dot com bubble, when it was fleetingly negative. (See Chart 1.)
- Admittedly, a gradual increase in the real yields of Treasuries that partly closed the gap could conceivably sour the mood in the stock market. But how much would probably depend on the reason for the rise. If it resulted from a stronger economic expansion, the adverse effect on equity prices would presumably be less than if it were due, say, to the Fed rowing back on its new flexible average inflation targeting framework.
- What’s more, even if an increase in the real yields of Treasuries did reflect a change in the central bank’s reaction function, we doubt the stock market would tumble a long way if it happened now, simply because there isn’t the same degree of leverage in it that has produced forced selling and big drops in the past. We suspect that there would have to be a lot more speculative, debt-driven, inflation of any bubble to set the stage for a big correction in the market. We can envisage one in a few years’ time, but not imminently.
- We would caution against pinning everything on the outlook for interest rates, though, even if the stock market’s strength today seems to depend more than usual on them staying low. As Galbraith (1975) noted in The Great Crash 1929, “… it is in the nature of a speculative boom that almost anything can collapse it” (p. 113). The fact of the matter is that the eventual bursting of any bubble in the stock market will occur when investors have lost confidence in its ability to rise. That may be because, or in spite, of higher interest rates. It would be a stretch to pin the turnaround in sentiment in the autumn of 1929, for example, on higher interest rates, which also clearly didn’t prevent a bubble from inflating earlier that year. (See Chart 2.)
- Reference: Galbraith, J. K. (1975 edition). The Great Crash 1929. Penguin Books, p. 113.
Chart 1: Shiller’s Cyclically Adjusted Earnings Yield
Chart 2: Shiller’s Cyclically Adjusted Price/Earnings Ratio
Sources: Refinitiv, Shiller, Capital Economics
Sources: NBER, Refinitiv, Shiller, Capital Economics
John Higgins, Chief Markets Economist, email@example.com