Share

Frédérique Carrier
Managing Director, Head of Investment Strategy
RBC Europe Limited

Concerns are mounting as to whether financial markets may have entered bubble territory over the past few weeks. Certainly, instances of excessive behaviour in markets have become apparent, and, it seems, more frequent.

The usual key ingredients to form a bubble in financial markets include cheap credit or easy money and an enticing narrative, with both resulting in excessive behaviours and valuations. The dot-com bubble is a case in point. With central banks increasing money supply ahead of the transition to the new millennium and the new possibilities offered by the internet leading to a tantalising narrative, the Nasdaq went up more than fourfold from the beginning of 1995 until it peaked in early 2000. Then, with money supply starting to tighten, the bubble burst. By the end of 2002, the Nasdaq had lost more than 70 percent of its value.

Today’s financial markets are grounded on easy money, and many market observers are worried about the impact of a reversal of central bank policies when the pandemic ultimately ends. Such concerns are valid, in our view, but we see the situation as a growing number of red flags rather than a definitive sign that we are in a bubble that is about to burst.

Red flags accumulate

There are visible signs of excess in financial markets as loose monetary policy and record-low bond yields push market participants to take on more risk. There have been several examples recently of market participants displaying FOMO—the fear of missing out—and assuming consistently rising prices rather than rationally assessing the value of an investment.

Investor attitudes are being shaped by the headline-making gains of some high-profile issues. For example, the 35 percent gain made by Bitcoin in the first nine days of 2021, on the heels of a fivefold surge in price from March to December 2020; or the more-than-sixfold increase in GameStop shares in less than two weeks to Jan. 26; or even Tesla, now the fifth-largest stock in the S&P 500 by market capitalisation, with a market cap larger than that of the major U.S., European, and Japanese automakers combined.

Interestingly, some of these have an enticing narrative and are perceived as providing a foothold in the economy of the future.

Other signs of excess include the increased participation of individual investors (aka retail investors) in markets. Being stuck at home due to pandemic lockdowns and restrictions seems to have spurred an influx of day traders. Another marker is the volume of initial public offerings (IPOs), which has reached a rapid pace, with $347 billion worth of IPOs announced in 2020 despite the pandemic, more than double the $165 billion announced the prior year, per data from Bloomberg. Moreover, according to a University of Florida report, the median age of companies coming to the market as IPOs in 2020 was nine years. The median age of companies going public hasn’t been this young since 2007, the year the stock market peaked before the global financial crisis.

Stretched, but not overly

It would be remiss to ignore these warnings and we repeat our call for vigilance. But we see less evidence of bubble territory when we look at stock market valuations.

On the surface, U.S. equities appear expensive at 22.3x the 2021 consensus earnings estimate for the S&P 500. After excluding the five largest technology-driven stocks (Apple, Amazon, Microsoft, Google, and Facebook), which constitute more than 20 percent of the S&P 500’s market capitalisation, the forward price-to-earnings (P/E) ratio drops to 17.5x, according to our national research correspondent. This compares to a 10-year average of 16.4x for the S&P 500 as a whole, suggesting to us that while valuations are expensive, they are not significantly overvalued.

Current valuations are all above long-term averages
Index 2021 P/E ratio (x) P/E long-term average (x)
S&P 500 22.3 16.4
S&P/TSX Comp (Canada) 16.8 14.8
MSCI China 15.9 14.6
TOPIX (Japan) 16.3 14.1
MSCI Europe ex UK (Europe) 18.0 13.5
MSCI UK 14.5 13.0

Note: Long-term averages use time frames most relevant to each market given changes in constituents over the years. U.S. 10 years; Canada and Japan 20 years; Europe and UK 22 years; and China 5 years.

Source - RBC Wealth Management, Bloomberg; China and Japan data as of 1/28/21, all others as of 1/27/21

Valuations elsewhere are also elevated and above their long-term averages, but they remain far below the heights reached at the time of the dot-com bubble. These higher valuations are underpinned by bond yields which are currently at historical lows.

Equities’ currently high valuations are susceptible to declines if bond yields climb as the economy recovers. But we think any increase in yields will be contained this year, although the 10-year Treasury yield has the potential to rise to around 1.5 percent versus the current high of one percent, which if reached would leave it about where it was pre-pandemic and well below the 2.1 percent it averaged in 2019.

With elevated unemployment levels and a full economic recovery still years away, we believe the Fed will very likely maintain its current loose monetary policy stance, even if inflation picks up over the next few months. Likewise, other major central banks are likely to keep monetary stimulus in place. Tapering by central banks, or the reduction of monetary stimulus, is unlikely before early 2022, in our view.

Still, a pullback or correction cannot be ruled out, as much enthusiasm seems discounted in equity prices. The frothiest, most extended parts of the U.S. market would be most vulnerable, in our opinion. Difficulties with vaccine rollouts and delays in reopening economies that lead to disappointing earnings guidance could all trigger profit-taking.

How to position?

We maintain our Overweight stance in global equities, and we are willing to withstand possible volatility as we think equities will eventually move slowly higher over the course of the year. We expect the sector rotation into cyclicals that started in November 2020 to continue as the economy approaches a reopening. We would continue to look for exposure to more attractively valued cyclicals, without neglecting exposure to resilient defensive stocks.

This article was originally published in the Global Insight Weekly with the title "Bubble trouble?"


Non-U.S. Analyst Disclosure: Frédérique Carrier, an employee of RBC Wealth Management USA’s foreign affiliate RBC Europe Limited, contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not associated persons of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.

This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.

The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.

This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.

Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.


Frédérique Carrier

Managing Director, Head of Investment Strategy
RBC Europe Limited
We want to talk about your financial future.