Is there a bubble in financial markets?

Markets are past the phase of multiple expansion driven by ultra-easy financial conditions

The above title seems to be the topic of the moment among financial market participants. There are strong arguments both for and against, with investment luminaries taking both sides of the debate. Deutsche Bank recently conducted a survey of over 600 market professionals and almost 90 per cent of the participants agreed either strongly or partially that there were bubbles in financial markets.

So, the feeling is widespread. Among survey participants, a large majority felt that Bitcoin and US technology stocks were the two assets deep in the bubble territory. I would add Tesla and the SPACs (special purpose acquisition companies) to the list.

Bitcoin shows all the price action of a huge bubble. From its trough in 2019, it is up 1,000 per cent and in a parabolic fashion. In terms of speed and size of the run-up, it is only eclipsed by the Tulip mania bubble of 1636-37. Given the difficulty in valuing this asset, the regulatory risks involved and the daily volatility, buyers beware!

For the US technology space, the outperformance of the mega caps is well known. The top 10 mega caps now account for 30 per cent of the S&P 500, it was 10 per cent in 2010. The 10 mega caps have appreciated 3.5x in the last six years, the S&P 490 (ex mega caps) has only grown 50 per cent in this time. However, this is not where we see bubble behaviour. The price action is much more exaggerated for the smaller SaaS companies,  unprofitable tech stocks and recent initial public offerings. They seem to be in a full-blown buying melt-up driven by retail flows. Retail trading volumes have exploded, put/ call ratios are at cyclical lows and individual investor surveys show high levels of bullishness.

Tesla is now the sixth largest by market capitalisation in the world at about $800 billion, from  $75 billion at the beginning of 2020. Its value is equal to 80 per cent of the entire US, European Union and Japan auto market capitalisation (ex Tesla). This for a company that sold 500,000 cars in 2020. If you look at the market capitalisation of auto Original Equipment Manufacturers (OEMs), three of the top five are now EV (electric vehicle) companies. With NIO and BYD being fourth and fifth largest after Tesla, Toyota and Volkswagen. In 2019, the traditional auto OEM’s had a market cap of $1 trillion and the entire EV universe (Tesla, battery companies and EV start-ups) had a valuation of $200 billion. Today, the auto OEMs still have a capitalisation of $1 trillion, while the EV universe is worth $1.5 trillion. Clearly, the asset classes mentioned above are in bubble territory, but are US equities more broadly too?  

On valuations, they are expensive. The S&P 500 is somewhere between the 95th and 99th percentile on any valuation measure you can possibly think of. On market cap/GDP, at 140 per cent, this is a new high.  On the famous Shiller CAPE (cyclically adjusted P/E) we are at the second highest reading ever, crossing the 1929 peak, only surpassed by the tech bubble levels of 1999-2000.  However, when adjusted for interest rates, valuations are not in nosebleed territory. The fact is that long-term rates have never been as low and the earnings yield of the market (1/CAPE) is above long-term bond yields, something which has happened rarely since 1960. Any valuation model incorporating rates shows continued upside for equities relative to fixed income. Record low rates justify higher equity valuations, but how high? That remains a debate.

Illustration: Binay Sinha

Also, just because equities may outperform bonds does not mean they will deliver positive absolute returns. Both asset classes can deliver negative absolute returns over the coming years. The question to ask is, where is the bubble? In equities or fixed income? Data shows that $18 trillion of global debt has negative yields. Nearly 74 per cent of all global bonds (government and non-government paper) have yields below 1 per cent (source: DB). Nominal 10-year G-sec yields across the world are at record lows. Even real yields are negative across the world. If yields mean revert, we can have a huge shock to the system. This is where the ability of the Fed and other central banks to control yields becomes critical. Markets are implicitly assuming that the central banks will not allow bond markets to run riot and that potential inflation spikes will not scare fixed-income investors. This is the biggest risk to the bull market and the most critical assumption markets are currently making. We have seen the damage even a small rise in yields can cause, remember the taper tantrum of 2013? It really hurt risk assets. Everyone is convinced the Fed is on hold for another two-three years at the minimum.

 It is clear that unlike in the tech bubble of 2000, which was global, the bubble today is entirely in the US. International equities are at a much lower valuation compared to the US and their own trading history. As an example, in the UK, the CAPE is at 15, compared to its peak near 30 in the year 2000. In Germany, the CAPE is 20, compared to its peak of 50 in the tech bubble. Across these markets, equities are as cheap as they have ever been compared to bonds. Their price performance over the last six years has hardly been stellar either. The Stoxx 600 is only up 50 per cent over the last six years.

So what is an investor to do? There is an obvious reluctance on the part of institutional money managers to step off this party. As long as bond yields remain at record lows, financial conditions at extreme easy settings and signs of a strong earnings and economic rebound starting second half of 2021, markets may sustain for a while. Valuation is not a timing indicator and till rates move up sustainably, this rally may not peak out. It is true that the last leg of such a rally can be incredibly rewarding and difficult to just leave returns on the table.

If one can ignore the herd and potential career risk of selling too early, then it makes sense to start taking money off the table at least from Bitcoin, EV space, low quality/high beta mid-cap tech names in the US, SPACs and bonds. Redeploy capital into international markets, EM and more value-oriented equity names. While cutting risk, I would not sell out of equities, just move away from the more highly valued parts of the market. I don’t think this is the year 2000 again, where the bubble in one sector was large enough to bring the entire market down, not yet at least. Be careful, but this is not a time to rush into cash either. Make your portfolio more global and value-oriented.

 What will change my mind is the inability of central banks to keep yields in check, or a series of mutations, which render the vaccines ineffective. We would then be looking at a double-dip in terms of another global recession. All bets would be off. There would be no V-shaped or any-shaped recovery in that scenario. This would kill markets; we need strong earnings to compensate for some inevitable multiple-fade. Strong earnings are dependent on economic normalisation. Unless the vaccines work, there will be no normalisation. We are past the phase of multiple expansion, driven by ultra-easy financial conditions. We need earnings to kick in now for the broad markets to sustain. This is true of the US at least. Emerging markets have a path to do well in the coming decade, more on that in another article.

The writer is with Amansa Capital