Are we dancing the last dance?
In his January 2021 memo to investors, titled “Waiting for the last dance” Jeremy Grantham (from Grantham, Mayo, & van Otterloo) outlines his thesis on why he thinks the 12-year long bull market in US equities is about to end. He writes: “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behaviour, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000 (Tech bubble)”.
Now, 6 months since his memo, the S&P 500 has gained an additional 486 points (12.6%) and the long, long bull market has now become even longer.
Let’s have a closer look at Grantham’s bubble indicators and see if we can find confirming evidence in market data. Note the presence of confirmation bias in doing so. Then, we will see if we can find some evidence to disprove the bubble-thesis.
1. Extreme overvaluation
One of the most popular methods of measuring stock market valuation, is the Warren Buffett indicator shown below.
Total US Market Capitalization as a percentage of US GDP
In early 2020, before the Coronavirus crash, this indicator reached levels last seen just before the peak of the tech bubble in 2000. Now, in July 2021, this indicator has reached all-time highs with the total market capitalization of US equities at 205% of US GDP.
Another measure of equity market valuation is the Price to Earnings (PE) Ratio. See chart below. The stock market crashes of 2000 and 2008 clearly coincided with extremely high levels of this metric and we are yet again approaching all-time highs. More on this, later.
Price to Earnings Ratio of the S&P 500 Index (1960–2021)
2. Explosive price increases
Although the price increases of some sectors have indeed been explosive, such as electric vehicle manufacturers, clean energy producers and gene therapeutics, the broader S&P 500 index has been moving steadily higher, but not in a parabolic trajectory as the aforementioned sectors.
Parabolic price action of certain sectors versus the S&P 500 index
Over the past 5 months, since the top of these three parabolic sectors, they have consolidated and broken out of their bull-flag patterns. These patterns do not exhibit typical bubble-top characteristics. After such a bullish consolidation, it is not inconceivable that the uptrend continues from here.
3. Frenzied (debt) issuance
The chart below shows the level of US government debt as a percentage of GDP from 1945 to 2020. In the aftermath of the 2008 Global Financial Crisis, the US government accelerated their debt issuance to stimulate the economy which plunged into recession in 2009. This surge in issuance drove government debt (as a % of GDP) up to levels last seen after World War II. The further increase in the pace of issuance in 2020 (See vertical line on the far right-hand side of the chart) to fill the hole left by the Covid-19 crisis, far exceeded anything ever seen in history and US government debt as a % of GDP is now at all-time highs.
The major economies of the developed world, Europe, UK and Japan, all have similar trends in debt issuance by their respective governments.
4. Hysterically speculative investor behaviour
An important indicator of speculative risk taken by investors, is the total level of margin debt present in markets. Brokers allow clients to borrow on margin, should the client choose to take on market exposure in excess of their available capital balance. This is an indicator of how much leverage investors/speculators are taking in aggregate. The chart below indicates that margin debt is now at the same levels where it was just before the 2008 and 2000 market collapses.
his chart shows clearly that the 1973, 2000 and 2008 market tops were marked by excessive speculation with high leverage. However, this is not the only potential cause of market declines.
It seems that there is definitely evidence of Jeremy Grantham’s four “bubble markers” in the markets today. But does this really mean that it will play out the same way as in the previous bubbles, or “is it different this time?” (…The dreaded phrase in financial markets)
One compelling counter argument is, when looking at equity valuations from a risk premium perspective, then US equity valuations are not at extreme levels. In fact, they are in historically fair value territory at 4.5% ERP. See the long-term chart below.
US Equity Risk Premium (Yellow) 1960–2021
According to Investopedia, “the equity risk premium (ERP) is a long-term prediction of how much the stock market will outperform risk-free debt instruments”. In more practical terms, ERP is the risk premium required by investors to compensate them for the higher risk associated with holding equities over owning risk-free assets such as US treasury notes.
As stock valuations are calculated by discounting future expected returns, using the required earnings yield, the lower the required yield, the higher the valuation will be. The chart above shows that required yields have been compressing for decades, thereby pushing valuations higher and higher, while the ERP has been range-bound between 2% and 6%. The difference between the required earnings yield and the ERP is the risk-free interest rate. Now let’s have a look at this metric over the same period (as the ERP chart above):
Yields for Baa-Corporate bonds (Blue), Mortgages (Black), Aaa-Corporate bonds (Red) and 10 year Treasuries (Orange)
The orange line in the chart above shows the long-term decline of the 10 year US Treasury yield which is the risk-free rate used in discounted cashflow valuation models. From this chart and the previous one, it is clear that the steady decline in the risk-free rate is the reason for the decline in the required equity earnings yield, while the Equity Risk Premium has been trapped in a flat range.
When considering the current fair risk premium of 4.5%, one could therefore argue that stocks are fairly priced, and that high valuations are the result of low risk-free rates and not as a result of over-valuation of the stocks themselves. According to figure 6, the tech bubble top of 2000 occurred when the ERP went as low as 2%.
In other words: when considering the multiple expansion in figure 2, the range-bound ERP in figure 6 and the downtrend in the risk-free rate in Figure 7, The multiple expansion of equities over the past 40 years could have been the result of ever decreasing risk free rates and not due to a decrease in risk premium or market euphoria. According to this view ERP would have to get into the lower range between 2.0% and 4.0% to signal over-optimism in equity valuations.
The driver behind the long-term downtrend in the risk-free rate is of course accommodating and stimulative central bank policies (Controlling short-term interest rates and monetization of government debt).
Against this backdrop, it is not difficult to see why markets are more focused on central bank opinions than fundamental economic indicators.
Are we in a stock market bubble, a debt issuance bubble, both, or none at all? What do you think?
Disclaimer
The views expressed in this article are the views of Johan Kirsten and are subject to change at any time based on market and other conditions. This is not financial or investment advice, nor a solicitation for investment funds and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities.
