As markets continue to rise, May’s Market Voice analyses the latest data to assess if equity valuations are entering stock market bubble territory.
- Historically, equity prices are high and may be indicative of a stock market bubble. Equity yields have recently fallen in comparison versus U.S Treasuries and corporate debt suggesting the equities rally may soon run into resistance.
- House prices in the U.S. rose by 11 percent last year, acting as a further signal for a potential stock market bubble.
- However, there is unlikely to be major downturns in the stock market and house prices unless there is a sharp upturn in the inflation rate.
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In the annual outlook in January’s Market Voice, it was assessed that despite the second half recovery last year that equity prices were not overvalued. While the prospects for further equity gains still hinged on getting COVID-19 under control, it was deemed that with the Fed providing extreme accommodation, there was potential for the rally to continue at least into the second half of the year.
Since then the market has certainly not disappointed. The market closed last week at a new record high, up 12.6 percent from year-end and 25 percent from the pre-COVID-19 high.
Stock market bubble territory
As seems apparent, the pace of gains over the past year are historically extreme – the end-March y-o-y gain of 54 percent was the highest seen since 1936 – and the forward-looking price vs earnings ratio is at its highest level in almost 30 years. So it is reasonable to reassess the potential that valuations are reaching levels which can be considered entering bubble territory.
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Figure 1: SPX value and price vs earnings (PE) ratio (month-end data)
In May’s Market Voice, we return to the recurring theme that we’ve explored since the Fed embarked on quantitative easing: stock prices are clearly high compared to history, but are they high compared with other markets?
In early 2021, a key indicator was the comparison between dividend yields and Treasury and AAA corporate bonds. Despite the fact that rates rose roughly 50 basis points in the second half of 2020 at the start of the year, the SPX could still be considered cheap relative to bonds .
Historically, the SPX has offered a lower dividend yield than either U.S. Treasuries or AAA corporate debt, probably reflecting the greater potential for capital gains. While the spread moved against equities in the second half of last year, as shown in Figure 2 below, they were still in positive territory making stocks still cheap versus bonds.
This year’s surge in equity prices has eaten into the dividend yield, at the same time that bond yields have gained an additional 50 basis points.
The result of this, as is also apparent in Figure 2, is that equity yields are back to negative versus corporate debt and close to par versus Treasuries. While this still leaves them cheap versus long-term history, yield spreads are back to the middle of the range that has prevailed for the past decade.
The implication is that the equity rally should run into increasing resistance and that there is growing risk of a downside reaction to higher rates.
Figure 2: SPX dividend yield vs 10Y U.S. Treasury and AAA corporate rates (month-end data)
The notion of the equities being ‘cheap’ might be mitigated by the solid gains in the real economy in recent months but Figure 3 suggests the equity gains are running well ahead of the GDP rebound.
Figure 3 shows the ratio of the market capitalisation of the SPX (the cumulative market value of all stocks in the index) to nominal GDP. Over the past two decades, the valuation of the stocks in the SPX has generally mean-reverted to about 90 percent of nominal GDP.
During the 2000 dot-com bubble the stock-market valuation surged to a then record high of almost 130 percent of GDP and plunged to a low of just over 50 percent of GDP during the 2007 financial crisis.
In the wake of the financial crisis, the market-cap rose back to 90 percent but then moved to an extended higher range bounded by 105 percent and 125 percent, probably reflecting the unprecedented Fed policy of a near-zero policy rate. The ratio dropped to the 105 percent bottom of the range, but the subsequent rebound took the ratio through the top of the range to new highs.
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Despite U.S. nominal GDP gaining 2.26 percent y-o-y in the first quarter of this year, the market cap ratio has continued to climb reaching an unprecedented 165 percent.
The steepening of the yield curve is also an alarm bell for the market. The orange line in the chart is the spread of the 3M vs 10Y Treasury rates so a more negative number is a steeper curve.
Recognising that there are a lot of false signals, the onset of a steepening trend is a necessary – though not sufficient – condition for stock market valuation to fade relative to the market. This adds to the evidence from yield spreads that equities are going to have a hard time maintaining the rally without substantial positive news.
Figure 3: SPX market cap vs GDP and the U.S. Treasury Yield Curve (Quarter-end data)
That 2008 déjà vu feeling in house prices?
The recent gains in equities have been overshadowed in the media by the focus on surging house prices.
The Case-Shiller house price index was up last 11 percent last month on a y-o-y basis the biggest gain since 2013. While this is well below the 16 percent gains in the run-up to the financial crisis, it is raising concerns that house prices are once again experiencing a bubble.
Figure 4 shows that the aggregate value of U.S. real estate has been trending higher versus GDP for the past 50 years (in part, this reflects that the pool of developed real estate has been increasing over time).
While the ratio at about 160 percent is well below the 175 percent peak ahead of the financial crisis, there is still modest cause for concern.
Figure 4: U.S. real estate valuation vs GDP
The recent run-up has been unusually rapid and would suggest that some consolidation is due until GDP can catch up with housing prices.
The situation looks similar, though somewhat less dire, based on the Shiller-Case index ratio to GDP (adjusted to align with the land-value index) which has also jumped recently, but is lower relative to the pre-financial-crisis peak.
Figure 5 provides compelling evidence that there is little risk at this juncture for the kind of major decline in housing prices experienced in 2008. Total land value remains near historic lows relative to the SPX.
More importantly, due to the low level of interest rates, household debt service is also at historic lows, at only 9 percent of GDP. By contrast, it was 13 percent of GDP ahead of the financial crisis.
Figure 5: Land value vs the SPX and household debt burden vs income
The recent rise in house prices appear to be a bit overdone, but there is no reason that prices should be subject to a substantial decline unless a sharp rise in interest rates caused servicing costs to rise. And interest rates are only likely to rise if…
…2021 is the year inflation finally shows up
While there seems to be reason to be conservative for upside in both home prices and the stock market, there seems little risk of a major downturn in either market.
This benign outlook, however, could turn much more negative on a sharp inflation upturn leading to higher interest rates and a steepening of the yield curve. The January outlook on 2021 saw marginal risk of a significant inflation pickup and only late in the year.
Figure 5 shows that capacity utilisation is still very low, suggesting the recent upturn in inflation will not persist. However, the bottom in utilisation has lagged the upturn in inflation so it will take a few more months of benign data to have confidence – on this front – that inflation will not continue higher.
In the meantime, the situation on the job front is near a tipping point to signalling a sustained inflation uptrend.
The payroll picture is muddied by the volatility in the numbers this time last year, but the 233,000 April gain, while disappointing, was in line with the trend over the past six months suggesting the pace is above the critical level.
The payroll picture is muddied by the volatility in the numbers this time last year but – the disappointing 175,000 gain in April notwithstanding – gains have been trending at around 230,000 over the past six months, suggesting this pace is above the critical level.
The unemployment rate has come down sharply over the past year from a high of 15 percent. It stabilised over the past month at 6.1 percent – on the verge of the critical level – so it looks like there is significant risk of inflation turning less benign in the coming months.
Figure 6: U.S. CPI (Y/Y) inflation and (12M average) capacity utilisation
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