Far too much is riding on persistently low bond yields.
The U.S. stock market is very expensive. Nobody can sensibly deny this. But is it truly in a bubble? There is a big argument that it isn’t, which comes from the bond market. Fixed-income valuations dwarf those on stocks. All else equal, bonds this expensive justify paying a higher price for equities.
On that basis, markets may be in the grips of exuberance, but it is rational exuberance. And the argument shifts to one about bonds.
Some significant luminaries are taking sides. My long-time colleague and mentor Martin Wolf argues in the Financial Times that, in as many words, there is no stock market bubble. The greater point, he contends, is whether rock-bottom interest rates will revert to normal, and if so when. Even Robert Shiller, the Yale University economist who built his reputation by identifying the bubbles that burst in 2000 and 2008, wrote last month that we should at least expect stocks to outperform bonds for the foreseeable future.
The most famous stock-market valuation indicator is Shiller’s cyclically adjusted earnings multiple, or CAPE. His latest update, from mid-December, put CAPE at 33.4. Feeding in the latest S&P 500 number, which topped 3,800 for the first time on Thursday, suggests that it is now more like 34.6.
At these levels, the CAPE has been more expensive for only a few months, in early 1998 and then — after the Long-Term Capital Management crisis and the cheaper money that came in its aftermath — from November 1998 to February 2001. At the time, it felt as though we had moved from an expensive bull market to something qualitatively different; a kind of collective madness. Returning to such territory is terrifying. But the red line showing long-term rates is at comfortably its lowest point ever, in a chart that goes back to 1880. Does that mean concerns of a bubble are overstated?
No, argues Jeremy Grantham, the 82-year-old market seer and founder of GMO in Boston, whose latest letter to investors starts thusly:
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 behavior, 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.
These are big claims. Wildly excessive valuations are only a necessary condition. They don’t tell us whether this is a true bubble, and they don’t help with timing. Grantham has a (not wholly deserved) reputation as a bear; in the past he recommended exiting and re-entering the stock market close to the top and bottom of the GFC, but was far too early in warnings about the dot-com bubble, calling to exit in early 1998, some two years before the eventual peak.
He admits that was painful. But he argues: “You have to think in terms of being hurtful or helpful, rather than right or wrong. The hurdle to clear is whether you would be grateful to be out of the market. And at some future date, whenever that may be, it will have paid for you to have ducked from midsummer of 2020”.
As he points out, there is too much stress on trying to time the top. The 2000 market gave investors ample opportunity to escape, while seven years later the U.S. stock market peaked almost a year before the Lehman bankruptcy:
Grantham told me:
Of course sooner or later it’s going to happen. The best indicator of these tops isn’t value — it’s crazy investor behavior. They are impossible to get right to the week or the month. This is a different cycle of course, but they all have similarities. That it ends with crazy investor sentiment is classic. And here we are.
So, let’s go through the indicators that this is a true bubble.
We don’t need a measure as complicated as CAPE. This is the price-sales multiple of the S&P over the last 30 years:
More remarkable is the performance of small-cap stocks, which have surged in the last few weeks. Since the bottom in March, they have gained 111%. Now they have outstripped the “mega-caps” of the Russell Top 50.
Over time, smaller companies are regarded as more risky and might be expected to provide a stronger return. But as this chart shows, past earnings cannot possibly justify the Russell 2000 at these levels:
The P/E of the Russell 2000 topped at above 10,000 last month. For the last three weeks, the index hasn’t had a P/E because on aggregate it has had no E; the losses of its constituent companies have more than counterbalanced the profits.
The chart also shows the S&P 600 small-cap index, which differs from the Russell by requiring that companies have a history of profits before they are included. Even this more conservative small-cap index now trades at a record P/E of 62. This is bonkers.
Grantham’s critical measure is mad behavior rather than valuation. Moving to crypto-currencies, which multiplied several-fold last year, we find that Bitcoin is up 35% in the seven trading days of 2021, while its less famous rival Ethereum has gained 70%:
There are many questions over whether governments, which hold a monopoly over issuing fiat currency, will continue to tolerate crypto-currencies. None of those questions appear to be weighing on investors at present.
Looking at direct measures of speculation in the stock market, my colleague Sarah Ponczek pointed out that Wednesday, or “Insurrection Day,” saw the fourth-highest volume on record in call options, used to bet on a higher market:
In the final “Ponzi” stage of a bubble, price appreciation tends to accelerate, as investors bet that they will be able to sell to someone else for even more, rather than bother to look at the underlying fundamentals. It looks as though we might have reached that point.
This is without mentioning the vogue for special purpose acquisition companies, or SPACs, which own and do nothing, but hope to buy another business — distinctly reminiscent of firms that IPO-ed without profits or even revenues in 1999. Small wonder that Grantham says that “I see this as the real McCoy. It could go any time. All we are waiting for is a bump in the road.”
Bonds and Catalysts
This raises the question of how big that bump needs to be, and whether the market will ever cross it. There are reasons why bubbles might last longer now than they used to do. Most important is career risk. Institutional investors are paid according to the amount of assets they manage, rather than by performance. That means they are better off being in the middle of the herd than making a big bet. Paul Woolley, one of Grantham’s former colleague who is now a professor at the London School of Economics, has developed broad theories to put “career risk” at the center of speculative bubbles and market dysfunction.
Beyond that, it is necessary to look at the bond market. Rock-bottom yields provide money to finance speculation, and justify discounting companies’ future earnings at a lower rate, thus giving them a higher valuation. Martin Wolf is correct to boil down the critical questions as follows:
The big questions are whether real interest rates will jump, and how soon. Will these structural, decades-long trends towards ultra-low real interest rates reverse? The answer has to be that real interest rates are more likely to rise than fall still further. If so, long-term bonds will be a terrible investment. But it also depends on why real interest rates rise. If they were to do so as a product of higher investment and faster growth, strong corporate earnings might offset the impact of the higher real interest rates on stock prices. If, however, savings rates were to fall, perhaps because of ageing, there would be no such offset, and stock prices might become significantly overvalued.
Some major stock markets, notably the UK’s, do look cheap today. Even US stock prices look reasonable, valued against the returns on safer assets. So will the forces that have made real interest rates negative dissipate and, if so, how soon? These are the big questions. The answers will shape the future.
Low real yields aren’t the unique creation of central bankers in the post-GFC QE era. On the contrary, they have ground lower ever since the Federal Reserve under Paul Volcker convinced investors that he had tamed inflation in the early 1980s:
As Wolf says, there are deep-seated trends behind the decline. The arithmetic is difficult to avert; while rates stay at such low levels, there is strong support for equities.
Grantham, however, emphasizes economist Hyman Minsky’s dictum that “stability is unstable.” As far as he is concerned, this is the first time ever that a bubble has formed on top of a weak economy, entirely supported by faith in low rates.
Central bankers, he contends, have created a perceived guarantee that rates won’t be allowed to rise, because they seem determined to thwart asset price deflation. This creates moral hazard — the propensity to take extra risks when you believe you won’t have to bear the negative consequences. Grantham paraphrases Minsky as follows:
The longer the moral hazard runs, and you have this implied guarantee, the more the market feels it can take more risk. So it takes more risk and builds yet more debt. We’ve counted too much on the permanence and the stability of low rates and low inflation. At the end of this great cycle of stability, all the market has to do is cough. If bond yields mean-revert even partially, they will be caught high and dry.
He also makes the argument, based on his own research, that earnings multiples are a function of two things: profit margins and inflation. Creeping consolidation has allowed margins to expand, but they are currently under pressure. A rise in inflation, which would put upward pressure on bond yields, could be critical.
Just how can the bond market rein in the stock market, though? BCA Research Inc.’s strategist Dhaval Joshi offers the following model, based on the spread between the forward earnings yield (inverse of the P/E) of global technology stocks and the 10-year Treasury yield. Low bond yields have made for a very wide spread at several points in the last few years, which bolsters the performance of tech stocks. But that spread has dipped to around 2.5% four times in the last four years — before the stock slumps of February and December 2018, the more minor dip of spring 2019, and just before the great Covid-19 sell-off early last year. The recent rise in the bond yield has brought that spread tighter than on any of those occasions:
As Joshi points out, all the previous points triggered an exhaustion or correction in equities. The question raised by Albert Edwards, investment strategist at Societe Generale SA, is whether yields would need to rise so fast to break the equity market this time, given that valuations are much more stretched.
Thomas Tzitzouris of Strategas Research Partners made another attempt to quantify when a rise in bond yields can dislocate stocks using the term premium — the extra yield investors demand for lending over longer periods. Tzitzouris says:
we’ve observed 2 interesting phenomena over the last decade; 1) using the Strategas term premium model, 10s have struggled to hold a positive term premium for more than a few days and 2) when the term premium has reached above positive 15 bps, beta assets (equity and credit particularly, but also potentially gold as well) begin to sell off. Right now we estimate that the fair value of the 10 year is about 1.01%, and rising, so that a 10 year yield of 1.05% results in a positive term premium, but below the threshold that would concern us. But if 10s make a quick move to 1.16%, all else equal, this would be a level where equity and credit outflows could begin.
At the time of writing, the 10-year yield has reached 1.098%, having gained 18.5 basis points so far this year. That hasn’t stopped some startlingly self-confident behavior in the stock market; and the same is true of this week’s ephochal political shocks, which have made scarcely a dent on animal spirits.
And that leads to what I think is a point of agreement. Far too much is riding on persistently low bond yields. As Grantham says, all the market has to do is cough.