Is a stock market bubble inflating close to a bursting point?

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

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.