Are equity markets in a bubble?

Bubbles and valuations

Investment discussions at the start of 2021 are largely being dominated by one topic – are we in a bubble? Those arguing that we are can point to numerous examples of exuberant investor behaviour. Share prices of some stocks, especially in the US, have been soaring – and by far more than could be justified by any change in their fundamental prospects. More broadly, investors are using today’s ultra-low interest rates as a justification for lower yields on all assets – and corresponding higher asset prices.

Some of the conditions necessary for a bubble certainly appear to be in place – with the key ones being loose monetary policy and exciting narratives based on new technology. And yet, while markets have rallied a long way, there is also evidence that we are not yet in bubble territory.

The key area of debate is around valuations. Our view remains that while valuations are undoubtedly rich, they are not excessive in all areas of the market. To a degree, today’s high valuations can be justified by improving earnings and even higher bond valuations. Below, I have tried to outline some of the key indicators we are monitoring, as well as the rationale behind some of our recent investment activity.

Valuations and earnings

To truly say we are in bubble territory, we need to have excessive valuations. It is easy to point to the valuations of some US consumer discretionary and technology stocks as evidence of this. Tesla’s historic earnings multiple of 1,395x and, slightly more modest forecast earnings multiple of 213x, is the most obvious example. However, there are two reasons to suggest that equity markets as a whole are not excessively valued. Firstly, after a difficult year for more cyclical sectors, the valuation disparity between “growth” and “value” sectors moved to all-time highs. With an improving outlook, there remain relatively attractively-valued opportunities in global cyclical sectors seeing more positive momentum in analysts’ earnings forecasts for the year ahead.

^{Source: Bloomberg, MSCI, Cazenove Capital, 26th January 2021}

Similarly when assessed on a regional basis, there remain attractive opportunities in areas such as emerging markets, particularly relative to more expensive markets such as the US. While emerging markets, trading on a forward PE of 19.9x, are expensive in the context of their own history, they are trading at close to the cheapest level of the past 50 years relative to the US, while also seeing earnings forecasts moving higher.

^{Source: Bloomberg, Cazenove Capital, MSCI. Valuation data to 31st December 2020, earnings and sales data to 18th January 2021}

Secondly, while interest rates and bond yields remain anchored (which we expect will remain the case for the next 12 months at least) equities continue to offer some relative value from a multi-asset perspective. With governments bonds offering incredibly low yields, many multi-asset investors have come to the conclusion that “There Is No Alternative” to equities (the TINA effect).

What are we monitoring?

Key variables which we continue to monitor closely include bond yields and revisions to earnings estimates.

Bond yields are very important in the current market environment. Growth sectors which have been leading the equity market rally are very sensitive to bond yields and have benefited hugely from low and falling yields. Valuations in these sectors are high. If we were to see yields rise, these sectors (and markets with high exposure to them, like the US) would look increasingly expensive. More generally, higher rates would increase borrowing costs, profit margins would fall and investors may reassess valuations.

High valuations can be justified by strong earnings growth. In other words, investors might expect to pay more for a company with strong earnings potential. However at current valuation levels, there is very little margin for error. Investors are less likely to take earnings disappointments in their stride - which could result in volatility. At this stage, we still expect to see positive earnings growth this year, across both growth and value sectors. However, earnings disappointment remains a risk we continue to monitor.

Liquidity

Another important variable is liquidity. As economies begin their recovery from the effects of Covid, we expect the provision of liquidity to remain supportive in 2021. The Georgia Senate race, resulting in a “Democratic sweep”, should also result in a higher level of fiscal spending in the US. So in the near term we do not see the withdrawal of liquidity as a meaningful risk to our base case. However, current conditions can not go on forever. Any suggestion of a normalisation of monetary and fiscal policy could see certain assets and equity sectors suffer.

We continue to monitor the rate of change of money supply and fiscal spending plans given the importance these factors have played in supporting equity markets over the past year.

Sentiment

The formation of a bubble is usually accompanied by exciting narratives that encourage people to invest regardless of a logical assessment of the value. We have seen a growing number of examples of this over the past couple of months – the rapid appreciation of Bitcoin, the continued rise in Tesla shares and, more recently, speculative trades in GameStop shares. More broadly, investor sentiment has certainly improved, but is not yet in territory associated with over-exuberance – and which might be regarded as a “sell” signal.

What action have we taken?

At this stage, we are happy to maintain our overweight equity positioning across models. There are clear risks to the outlook, but our base case remains that the distribution of the vaccine will allow for a pick-up in economic activity in the second half of the year which will benefit earnings, while liquidity will remain supportive.

While we do not yet believe we are in bubble territory, we are conscious of the expensive valuation of certain areas of the market. We have therefore chosen to further reduce exposure to traditional “growth” sectors such as technology and, as a result, our US equity weighting. Overall, we have slightly rotated portfolios towards more cyclical sectors and regions. This includes an addition to an emerging markets fund, which has significant holdings in natural resources. Companies in the sector should benefit from a pick up in global growth and, despite recent strong performance, we feel there is still potential for continued recovery after a challenging 2020.

We continue to maintain our exposure to more defensive assets. There are signs that investors are becoming complacent about some of the risks to markets. With this in mind, we believe it is prudent to hold some defensive ballast within portfolios.