In the past few weeks not a day has gone by without at least one report pointing out how global financial assets, especially in the United States, are in the midst of a huge bubble. Most expect these bubbles to break in short order and cause serious financial pain to anyone who’s foolhardy enough to remain invested in financial assets. One can see the reason for this huge concern. Investors are convinced that the US Federal Reserve is manipulating asset prices to boost consumption and kick-start it towards its past trend.
Take, for instance, the corporate debt market. The search for yield has driven investors to move out on the risk curve. The yield on a three-month corporate debt in 2007 was higher than what most junk bonds yield today. Average yields on investment-grade debt globally recently dropped to less than 2.5 per cent. Noted bond market investors have pointed out that almost one-third of new bond issuers have credit ratings of CCC or below (almost default ratings), and that 60 per cent of all new high-yield debt issuances are for refinancing existing debts – which implies that issuers are unable to repay the debt with current cash flows. Debts worth $500 billion will be due annually between 2018 and 2020. Much of this debt will not be repaid and will have to be refinanced. If debt market conditions are not amenable to cheap refinancing, we could see some very serious stress in the credit market. Even for government securities, if yields were to simply normalise to the average of 2000-2010, 10-year bond prices will be down over 20 per cent. The risk-reward ratio for debt market investors seems to be skewed, and one could argue that risk-adjusted returns in this asset class are unattractive.
As for equities, the cause for concern is the inflation in valuation ratios. Price-earnings multiples have expanded by about 18 per cent in 2013 and have accounted for the bulk of the 24 per cent return in the S&P 500 so far this year, as earnings growth has begun to stall. Profit margins at 12 per cent (post-tax margins/gross domestic product) are at a record high. Moreover, in the face of muted revenue growth, profits can no longer outpace sales and grow in double digits.
The bears use Robert Shiller’s price-to-earnings (PE) ratio to buttress their bubble argument. The Shiller PE uses the 10-year average of inflation-adjusted earnings as the denominator; it has a very good record in terms of predicting future equity returns. At a current reading of nearly 25, it is 50 per cent above its historical median and within the top decile of all observations since 1881. According to Mebane Faber Research, 10-year future real median returns would be -15 per cent from the current starting point on the Shiller PE.
To add to the valuation discomfort, margin debt at the New York Stock Exchange is at an all-time high; sentiment indicators show very little bearishness; and the volatility index indicates investor complacency. A frenzy is also developing in internet stocks once again. Central banks are targeting higher equity prices, pumping in huge amounts of liquidity to make sure prices keep on rising.
Given that valuations are seemingly stretched, sentiment is bullish and everyone wants to play this rally till the very end, one can see why the bears are worried. High multiples on inflated profit margins, an implicit belief that one cannot fight the US Federal Reserve, and the complacency and disregard in the markets around the muted economic outlook – everything indicates that we are moving into bubble territory.
The bears and believers in an equity bubble in the US seem to hang their hat on the Shiller PE – for it is hard to argue that 15 times earnings (the current S&P 500 valuation) are over the top, with rates at 2.6 per cent. The argument that this 15 times is on peak-of-cycle earnings and margins are inflated also does not seem to account for the secular rise in the share of overseas earnings for corporate America (over one- third now). BCA Research has made adjustments for this secular rise in overseas earnings, which shows that domestic profit margins are not at an all-time high; they are similar to the peaks of the 1970s, 1990s and 2000s, and are lower than the average margins of the 1950s and 1960s. Any interest rate-based valuation tool is dismissed as being irrelevant, given the artificial nature of current interest rate levels.
While the Shiller PE has a good long-term track record, the fact remains that it has been below its long-term median for only 11 months since January 1990. If in 23 years, the ratio was below its long-term median only four per cent of the time, has something changed? Maybe the secular decline in interest rates?
Jeremy Siegel has also recast the Shiller PE using a broader measure of corporate profits from the national income accounts rather than real S&P 500 earnings; he argues that huge accounting write-offs in the financial crisis have artificially depressed S&P 500 earnings. His recast Shiller PE shows that markets are slightly undervalued, with the likelihood of delivering positive real returns in the next five years.
Be that as it may, whether we are in an equity bubble or not is something we will only know ex post facto. I still feel equities both in the US and globally have at least one more leg to go, as I have never seen markets peak out at only 15 times earnings – at such low interest rates and with such easy liquidity.
Indian policymakers must use what is left of this equity bull market to put our house in order. We have more than $250 billion of foreign institutional investor ownership of our equity markets, and any reversal could be a serious threat to the country’s macroeconomic stability. There seems to be a sense of satisfaction in Delhi that the rupee crisis is over and that we have done enough to tide ourselves over our macroeconomic difficulties. This would be a mistake. A crack in equities globally, risk aversion or renewed pressure on emerging markets, and we are back to square one. We have to regain the sense of urgency that we saw in August. India, however, continues to face serious challenges in terms of inflation and growth. We have enough low-hanging policy fruit that, if we execute, irrespective of global market price action, our markets can do well.