A Fascinating Way To See Bubbles Within The Stock Market

Asset bubbles are notoriously difficult to identify as they are happening.  Often times, they only become clear in hindsight. Having said that, Goldman Sachs’ David Kostin offers an interesting stock  market chart in his team’s new US Quarterly Chartbook. It shows the sector composition of the S&P 500 by market cap since 1974.

As you can see, sector bubbles manifest when they suddenly explode as a  percentage of the S&P 500. The dotcom bubble is very prominent, represented by the ballooning info tech  sector stocks. The credit bubble appeared much more gradually as seen in the  rise of financial sector stocks. “Financials was only the third sector since 1975 to represent 20% of the  market capitalization of the S&P 500,” noted Kostin. “However, Financials  share of the S&P 500 market cap has declined from 22% to as low as 9% in  early March 2009.”

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US Stock Market: are we in a bubble?

In recent posts, I have made the case for why U.S. equities are not in a bubble, noting that valuations are still far from past peaks. That said, given the relentless rise in U.S. stocks, it’s hard to argue with the fact that certain market indicators, including a few valuation metrics, are flashing yellow. To gauge when (and if) the market has officially tilted into bubble territory, I would suggest that investors focus on two sets of data: valuation and sentiment.

1. Valuation. My main argument against a bubble in U.S. equities is that while valuations are no longer cheap, they are a far cry from previous peaks. However, some measures – notably the Tobin Q Ratio, gross domestic product (GDP) to market capitalization, and the Cyclically Adjusted P/E – are high, arguably too high.

I would pay particular attention to the Shiller P/E Ratio, which is a variation on the Cyclically Adjusted P/E or CAPE. This indicator is worth watching as it has historically correlated with long-term stock market returns. Today’s reading, in the mid 20s, suggests below average returns in coming years. A further advance would suggest a more serious problem. By way of comparison, the indicator reached a high of around 30 prior to the 1929 crash and was close to 45 in 2000.

2. Sentiment. While valuation is important, investors should also pay attention to sentiment. The goal is to gauge how – to steal a phrase – “irrationally exuberant” investors have become. In measuring sentiment, investors should focus on two types of indicators: what are investors doing and what are they thinking. Read more »

Here’s What Has Been Driving The Stock Market Since 1960

The S&P 500 is already up 26% since the beginning of 2013, and almost all  of those returns have been driven by an expansion in the multiple investors use  to value the market as opposed to actual growth in companies’ earnings. “Year to date, 75% of the S&P return  has come from its [price-to-earnings ratio] expanding to 16.5x from 13.7x trailing EPS at 2012 end,” writes  Deutsche Bank chief U.S. equity strategist David Bianco in a note to clients.  “Excluding 2009, this is the largest [valuation multiple] contribution to market return since 1998. Before  assuming further [multiple] expansion we think it is important that investors be  confident in healthy EPS growth next year. Hence, we encourage frequent re-examination of the capex and loan outlook upon new data points.”

The chart below decomposes S&P 500  total returns for each year since 1960 into the contributions from multiple  expansion, earnings growth, and dividend yield. “In our view, further S&P [multiple] expansion from 15x 2014E EPS  today would be justified if long-term Treasury yields slowly rise as the Fed tapers, but plateau below historical norms (~4% 10yr, ~2% 10yr TIPS or less),”  says Bianco. “The less the Fed’s balance sheet expands in 2014 the less the risk  that yields rise above historical norms when QE ends or when the Fed’s balance  sheet contracts.”

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