Equity markets are frothy and will probably run hot for a while, say investment banks


Global share prices are looking ever more frothy and talk of a bubble has grown ever louder, but Morgan Stanley and other investment banks see equities as having further to run.

Last year and into 2021 there has been a surge of retail investor activity and dramatic runs in cryptocurrencies, electric vehicle manufacturers and ESG funds, record levels for US stock indices and record volumes, a hot IPO market and a frenzy of demand for SPAC vehicles (US cash shells), with the new year also seeing a headline-grabbing trend for ‘meme stocks’ and ‘YOLO trading’ sparked by collective investment groups on Reddit.

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Strategists at JPMorgan Cazenove said they had been receiving “numerous questions about whether a bubble is potentially forming in financial markets”.

A widely circulated research article from investment veteran Jeremy Grantham at GMO earlier this month argued that the “long bull market since 2009 has finally matured into a fully-fledged epic bubble”, adding that “for the majority of investors today, this could very well be the most important event of your investing lives”.

Over at Citigroup, analysts acknowledged that equities “are looking increasingly frothy”.

How bubbly is this bubble and is it a bubble at all?

However, they said the current stock market performance and valuations still lag previous “mega-bubbles”.

For example, the Nasdaq index trades on a cyclically-adjusted price-to-earnings ratio (CAPE) of 58 times, compared to 113x in the dotcom mega-bubble of 2000, or Japan’s 83x in 1990.

To use the CAPE or Schiller PE measure, popularised by Nobel laureate Robert Shiller, you divide the price of the index by the average of its earnings in the last ten years, and adjust everything for inflation.

This smooths away cyclical ups and downs in earnings, to give a less jumpy picture of the market’s valuation.

The US stock market was also this highly valued before the 1929 market crash that signalled the beginning of the Great Depression.

Comparisons like these make people nervous, said analyst William Ryder at Heargreaves Lansdown, “mainly because they believe that the market is likely to revert to its long run average. However, interest rates have also fallen precipitously in the last few decades, which has important implications for valuation.”

The UK surely isn’t in a bubble

Any investors worried about excess valuation, should look outside US equities, said Citi strategist Robert Buckland, suggesting the UK as the team’s “current favourite value trade”, where the CAPE is just 15x.

Past equity bubbles hit much higher valuations than now, Buckland noted, but with bonds in those times at 5-6%, not 0-1% as now, meaning they are not the obvious alternative as in previous times.

“Perhaps equities are currently vulnerable to any hints of higher rates or QE tapering from central banks. But history suggests that bubbles can inflate even as rates start to rise. They are much more robust than we all think.”

Whether or not we are in a bubble could be debated, agreed JPMorgan equity strategist Mislav Matejka, with his response being similar.

Either way, how long will it last? 

“Irrespective of the answer to the bubble question, we think that the ‘excess liquidity’ theme, which is often blamed for these kind of moves, is unlikely to disappear.”

Central banks, said Matejka, are sufficiently worried about a rerun of Japan’s ‘shrinkflation’ scenario that they will keep rates low and the quantitative easing taps running on full until the end of this year at least, meaning there will remain plenty of liquidity in the market.

“that they might end up letting financial markets run hot until the economy itself starts overshooting.

“They are likely to err on the side of caution, thereby visibly falling behind the curve, as they would want to see a clear strength in a range of activity and pricing variables before changing course.

“Ultimately, that is what a changed framework/AIT is all about, with the proverbial removal of the punchbowl unlikely before the end of this year.”

The whole idea of a bubble is wrong anyway, says Ryder.

“Long run CAPE or PE comparisons may be a misleading tool when trying to assess stock market valuations because interest rates vary over time and are a key determinate of asset values.

“As interest rates have fallen over the last few decades, we should expect stock markets to trade at a higher level. To test this theory we can look at other valuation measures, and when we do the market doesn’t look overvalued.”

This doesn’t mean individual companies aren’t overvalued, or under valued, said Ryder, some might well be so.

He said it is a risk investors should consider on a case-by-case basis.  

“It’s also not to say stock markets can’t fall from here. They definitely could. Earnings growth could fail to live up to expectations, or expectations of future earnings could change. If so, the market would fall.

“Similarly, if interest rates rose the same process explained above would play out in reverse, and the market is likely to fall dramatically, all else being equal.

“However, shares aren’t necessarily overvalued just because there are risks. An overvalued investment is one that will struggle to deliver returns that appropriately compensate for the risk taken even if all goes well.”


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