Stock Market Bubble Valuations

third-wave-finance-2-16-2017

When addressing stock market bubbles it’s important to consider multiple valuation methods to gain a clearer view of where the bubble is concentrated.

While there are other — more preferable/accurate — methods of stock market valuation, a useful “first stop” would be Robert Shiller’s Cyclically Adjusted Price to Earnings Ratio (CAPE) for the S&P500 stock index.  The history of this valuation metric from the late-1800s to present can be seen below.


shiller-pe-ratio-1Source Data: Robert Shiller’s CAPE Ratio


After viewing Shiller’s CAPE ratio, it should be obvious that investor complacency is running high; the S&P500 index is currently at valuation levels associated with massive investment bubbles.

But viewing the overvaluation from different angles using reliable valuation metrics can yield a clearer picture of the severity and concentration of the existing bubble.

Using the valuation methods below (which have a slightly more accurate correlation with future outcomes than the Shiller Ratio), one can see that the existing S&P500 stock bubble is more extensive than the bubble preceding the housing crisis, but not at as extensive as the bubble preceding the dot-com collapse; however, it is important to note that these valuation metrics are based on the S&P500 index which is capitalization-weighted (more heavily weighted to the largest sized companies).


hussman-valuations

Source: John Hussman’s weekly market comment on 2/6/2017 entitled, Portfolio Strategy and the Iron Laws


 

Looking at the overvaluation from an additional perspective — one that includes corporate equity and debt — one can see that the current bubble is more extensive than the bubble preceding the housing crisis, and about as extensive as the bubble preceding the dot-com collapse.


felder-valuationsSource: The Felder Report post on 12/7/2016 entitled, U.S. Corporate Valuations Have Now Matched Their Dotcom Bubble Peak


 

And finally, viewing the existing overvaluation from the perspective of a median-oriented S&P500 gauge (i.e. not heavily weighted toward the largest sized companies in the S&P500 index), one can see that the current bubble is the most extensive in history.


hussman-valuation-2Source: John Hussman’s weekly market comment on 2/13/2017 entitled, Time-Stamp of Speculative Euphoria


 

After viewing the existing stock bubble from several different angles via the valuation metrics above, and reviewing The Orchestration of Debt-Based Expansions, one should be able to see that:

  1. The dot-com bubble was very concentrated — focused in technology and internet stocks with a significant affect on the capitalization-weighted valuation metric.
  2. The housing bubble was somewhat more spread out among the stocks in the S&P500 index than the dot-com bubble was (see Median price/revenue valuation above); it included financial & mortgage related speculation.
  3. The current “yield-seeking / experimental monetary policy” bubble is even more spread out than the housing bubble (see Median price/revenue valuation above) and speculation has spilled over into the debt-market affecting credit-sensitive bonds.

As a reminder, valuations tend to weigh heavier over longer periods of time as they depend on the completion of a full business/debt-cycle to pull investor opinion — i.e price, see What Does the Price of a Security Really Mean? — back into alignment with valuation; this is why longer-term valuation projections have a higher accuracy.  Investor preference/popularity can push markets higher over a multi-year period, but over the course of 10-12 years the weight of valuation is felt.

The chart below shows that (with a 94% accuracy) the expected S&P500 return from now until 2029 (i.e. the forthcoming 12-year period) is about 1% per year(~12% total over 12-years); after accounting for dividends (using the current dividend yield of ~2%) one would see an S&P500 index level in 2029 that is about 12% lower than today’s level (CALCULATION: ~1%-expected-annual-return MINUS ~2%-current-dividend-yield EQUALS ~-1% annual return MULTIPLIED BY 12 years EQUALS ~-12% return). It’s important to note that the return expectation is skewed heavily negative over shorter periods (3-,5-,7-years) due to the severity of the existing bubble, but the likelihood of occurrence is slightly lower than the 12-year expectation because valuations are more accurate over time.

In this context, it’s possible that the S&P500 index stays relatively flat, dipping slightly each year over the next 12-years to complete the case below, but the stock market hasn’t moved in a flat line over a 12-year period before; it oscillates, sometimes wildly, due to investor psychology; this accounts for the hard negative expected return over a shorter period 3-, 5-, 7-years, and the slightly lower accuracy than the 12-year expectation.

Using the visual described in What Does the Price of a Security Really Mean?, think of an unstretched rubber band as valuation (the rubber band’s normal state); investor psychology (i.e. price) stretches the rubber band out of it’s normal state and either the rubber band eventually warps over time (valuation very slowly rises to meet the price — with little return to no return) or the more-likely event occurs: you give up or can’t hold the rubber band any longer and it snaps back.


hussman-valuation-3

Source: John Hussman’s weekly market comment on 2/13/2017 entitled, Time-Stamp of Speculative Euphoria


 

 

 




 

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