Yesterday we invited you to speculate for yourself whether there is a bubble in the US market or not. Today, we are going to give you our opinion. To get the right answer, you first have to ask the right question. Our question is: “Stocks are expensive compared to what, exactly”?
The average P/E (price to earnings) value for the S&P 500 index over the last 100 years is 16. The P/E value is now around 40. It looks like a bubble. But let’s ask another valid question. Why exactly was the average value of the S&P 500 previously around 16?
The fact is that for 95% of the 20th century, interest rates in the US were much higher than they are today. Which meant that investors were interested in putting money in the bank or buying treasuires, getting virtually risk-free 3%-7% per annum.
Today the situation is different. Yields on bank deposits and short-term trades are 0%-1% per annum. Against this background, P/E = 40 means that companies generate earnings per share of 2.5% p.a. And this is significantly higher and more interesting to investors than the interest rate on bonds.
Let us imagine that the P/E for the S&P 500 index would now be 20. Which would mean companies’ earnings per share of 5% per annum. What would investors do? They would rush out in droves to buy American stocks. What would happen to American stocks? They would immediately jump in value. For example, by 2 times. In that case the P/E-value would become 40. Does that sound familiar? But that’s exactly what we have in the market right now.
So the P/E = 40, which is 2.5 times the average, looks like a bubble only without zero interest rates.
We have the following. The market may fall, it may rise, but it does not look overbought from the perspective of an investor who chooses whether to invest free money in bonds or in stocks.
What could drastically change the situation?
Inflation in the US could surge by the middle of the year. We have been going into detail about why this will happen. Once restrictions are lifted, people will start to be active in spending money. And they are understandable. The population received a lot of money, and in the conditions of lockdowns they spent very little of it.
As a result, interest rates could start to rise. What happens when the 10-year Treasury yield exceeds 2%? Will it rise to 2.5% p.a.?
Investors will realise that there is a choice. Get 2.5% risk-free in bonds. Or risk 2.5% in equities, as measured by the S&P 500. Logically, a massive sell-off in equities and a transfer of money into bonds will begin. The P/E ratio should drop to, say, 25, giving a higher potential yield in equities of 4% compared to 2.5% in bonds. In which case, the market will come back into balance.
And what if the equity values don’t fall too much and the P/E remains around 40? In that case, we can state that a real bubble has burst in the stocks of the S&P 500 index, which will implode at any time.
Is it really that simple?
No, it’s not that simple. The market is insidious and cunning. The last two paragraphs are the logic of the average investor. But the average investor gets burned by the market all the time.
01.30 Australian retail sales for January
09.30 German Composite PMI for February
10.00 EU Composite Business Activity Index for February
10.30 UK PMI for February
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