November 13, 2013

Stock bubble fears: guarded vigilance or obsessive compulsive disorder?

When will the bubble burst? Cable business networks are filled with a sort of death watch for equities. The market is up 23% year to date, and the press is asking if this is too far, too fast.

Is the stock market revisiting “irrational exuberance”? Typical in these discussions are references to the run-up to the financial crisis of 2008–2009. I do believe that investors are well advised to reflect soberly on those days when bubbles burst and the average stock portfolio suffered severe damage.

Is the market rising only on the Fed’s fumes? We often hear the lament that the upward moves of stock prices are entirely due to the accommodative monetary policies of the US Federal Reserve and other central banks.

Be the first observer to predict the demise of a bubble and you’ll probably get to write a best-selling book and make millions. And there are a lot of contenders out there to call the next collapse. But is that what is going on now? Are stock returns driven by easy money, high spirits and crazy expectations? Or do fundamentals still matter?

Evidence for a bubble: Graphs are used to make the point that this is a stock market bubble, sometimes showing the Fed’s purchases of bonds — also known as quantitative easing, or QE — against the S&P 500 Index, with both rising hand in hand.

Source: Bloomberg. Data as of 11/6/13.

Others point to the S&P 500 moving ahead of its long-term relationship with trailing earnings per share, or EPS.

Source: Bloomberg. EPS as of 9/30/13, S&P 500 as of 11/12/13.

Both these charts do suggest that the path of the stock market has been related to QE and EPS. But this evidence of co-movements, or correlation, doesn’t imply causality.

Evidence against a bubble: Considering the stock market’s climb against other fundamentals — earnings, cash flow or even margins — shows a different story. The next-12-months forward price-to-earnings ratio of the S&P 500 has trailed the historical average during this whole cycle since 2009, only rising close to the average at the end of 2013. Based on this forward earnings multiple, it doesn’t seem that a bubble is underway.

Source: FactSet and IBES Aggregates. Data as of 10/17/13.

The market tends to look ahead, and third-quarter S&P 500 earnings have so far shown the following:
  • Revenue growth is up 4% year over year (excluding banks) — the best in four quarters.
  • Earnings-per-share growth is up 3.8% year over year (excluding banks).
  • Margins are steady near record highs of 9%.

So what are the fundamentals telling us? In my view, the fundamentals are strengthening from a very strong base — perhaps the strongest base in a generation. The financial condition of US companies is underscored by low debt to assets, high cash flow, ample liquidity and competitive returns on equity. The US economy is growing, and the rest of the world is showing signs of moderate acceleration. All this adds up to a market that is experiencing a cycle that is longer than the usual five-year run. As long as the cycle continues, we can expect to see more operating leverage — and even more profits and cash flows.

The wall of worry could come, but not until borrowing starts to accelerate and credit standards weaken. Those are the signs of a faltering cycle. Right now, however, company assets are still expanding faster than debt, and consumers are spending their current income, not borrowing from future income. What we’re seeing isn’t a recipe for recession or a collapse of fundamentals. Third-quarter earnings results have so far brought tidings of better times ahead — maybe as soon as this final quarter of 2013.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.


1 comment:

Alex Knapp said...

Hi Jim
Thanks for the update.

On top of all these points equities are also a good relative value: S&P forward earnings yield is 6.67% versus 2.73% on the 10yr, which gives a "Fed Spread" of 394 bps.

For context, in March of 2000 (bubble peak) the spread was NEGATIVE 290 basis points.

If fundamentals are strong and the asset class is attractive relative to alternatives, money will find its way there.

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