Many are concerned. We’re not. Here’s why.
Jonathan Linden, Senior Equity Strategist
Equity prices have risen quickly in the United States since the March 2020 low. So, too, have fears that the stock market is experiencing a bubble and equity valuations are unsustainable.
The percentage of Bloomberg news stories containing the word “bubble” hit a peak at the end of 2020 and remains high.
Online searches for “bubble” have skyrocketed
We are hearing concerns from clients. Investors are aware that the U.S. stock market and its traditional valuation metrics are near or at all-time highs, and hastily conclude there must be a bubble brewing. In their minds, the higher stocks go, the bigger the bubble—and the more damaging the ensuing selloff.
But here’s what we’d like our clients to know: We do not think equities are currently overvalued and, while spotting a bubble in real time is notoriously difficult and no one has a crystal ball, we do not think there is a stock-market bubble now.
We base our position on four criteria that we use to identify a bubble, which we define as: When an asset’s price grows faster than its fundamentals, making it susceptible to deflating quickly:
- Price momentum—Are asset prices appreciating too quickly? Fundamentals don’t usually change that fast, so asset prices shouldn’t either.
- Valuation—Is the asset price grounded in realistic growth and earnings expectations, based on underlying and relative fundamentals?
- Capital allocation—Are management teams overly optimistic about their business prospects?
- Market sentiment—Are investors irrationally exuberant?
Our short answers to these four questions are: Today’s price appreciation is actually well below those of past bubbles. Valuations (while elevated) look more reasonable on a free cash flow basis and relative to bonds. Management teams generally have a prudent approach to capital allocation. And market sentiment on the whole looks far from irrational.
Here’s the analysis that leads us to these conclusions:
1) Price momentum—too fast? Not if you look at current three-year returns
Sure, rapid price increases are the first signal most investors use to help identify a bubble.
But contrasting equity prices’ rise with other asset prices’ rise is like comparing apples to oranges: They have different volatility profiles. To create a valid cross-asset comparison, we use a measure called a z-score, which standardizes assets by comparing them to their mean and how volatile they tend to be. Over a three-year horizon, we identify the magnitude of asset price increases one should expect to occur less than 1% of the time (at least a 2.5 standard deviation move). Anything to that degree or greater could indicate a problem.
This technique has helped identify some past bubbles. What does it show now? Although mega cap U.S. technology stocks have rallied substantially (the NASDAQ is up roughly 100% from its March 2020 lows), their z-scores are still well below “bubble” territory.
Tech stocks’ three-year z-scores don’t indicate a bubble
2) Valuations—too high? Not if you look at the price-to-free-cash-flow basis or relative to bonds
You might believe there is cause for concern when the current S&P 500 price-to-earnings (P/E) ratio is about 22 times, while the 20-year average has been about 16 times. But just looking at P/E ratios in absolute terms doesn’t paint the full picture. Context is needed.
Yes, other metrics also are suggesting equities are historically elevated. Equities look expensive based on market cap/GDP, enterprise value/sales, enterprise value/EBITDA, forward P/E, price/book and operating cash flow yield.
However, each of these calculations fails to account for at least one of these essential structural changes:
- Increased free cash flow generation
- Higher profit margins
- Lower capital spending levels
Remember: P/E ratios are just a shortcut for discounted cash flow models. Stock prices are ultimately the present value of future cash flows. As such, we feel it is appropriate to look at cash-based earnings metrics when valuing equities. When we do, this is what we find: While today’s market is expensive on a P/E basis, the market is roughly in line with its historical median—and much lower than the dot-com era—on a price-to-free-cash-flow (P/FCF) basis.
While elevated on a P/E basis, equities look reasonable on P/FCF valuation
Why this discrepancy between P/E and P/FCF ratios?
For one, earnings and free cash flow are very different, particularly as it relates to capital expenditures (capex, investments in things such as factories, new machines, computers, etc.). When companies calculate their earnings, they smooth out capex over time. Free cash flow (FCF) fully accounts for such expenses when they actually occur. So, when companies increase spending on capex, earnings take a long time to reflect this spend, and thus are overstated.
It’s also all relative. While it’s important to look at equities relative to their own history, we also must examine them relative to macro conditions and other assets. The global economic backdrop has changed considerably over the last 30 years. Interest rates have declined significantly due, in part, to lowered expectations for both inflation and growth (10-year Treasury yields have fallen about 650 basis points, or bps, in that period).
Stocks look attractive today relative to bonds. To compare the two, we use something called the equity risk premium (ERP). The ERP is the excess return that investors require above that of a risk-free asset (usually the 10-year Treasury) to compensate them for the additional risk.1
When the ERP is wide, stocks are typically cheap (because investors require a bigger return premium to take on the risk and volatility of owning equities rather than Treasuries). The reverse is also true: When this spread is narrow, equities are more expensive (as investors do not require that much more return for the risk).
So what’s happening now? We expect that as uncertainty about the economy continues to fade in the United States, the ERP will remain close to its 20-year average of 3.5%. That understanding is based on our view that:
- The S&P 500 should end 2021 at 20 times our estimated 2022 EPS (a P/E multiple of 20x)—which means the estimated earnings yield would be 5%.
- The 10-year Treasury will reach 1.5% by the end of 2021—which would mean the ERP would be 3.5% or 350 bps (to derive an earnings yield of 3.5%2).
What if interest rates continue to rise? Right now, we think rates are rising for “good” reasons—higher growth and healthy inflation expectations. If rates continue to increase (say, to about 1.7% by year-end, helped by fiscal stimulus), we think stocks could comfortably absorb the increase.
There’d be a risk to equities only if rates rose sharply and at an accelerated pace.3 But we think the probability of this sudden revving is low, given the Fed’s new thinking that inflation must average 2% before it would consider hiking rates. Still, if the Fed has difficulty communicating its plan to taper asset purchases later this year or early next year, we think rates could temporarily rise as much as 75–80 bps. Yet, even if such a pullback occurred, this should not result in a market crash—we believe even a rapid 100 bps rise in rates would cause only a 10%–15% stock market correction
3) Capital allocation—too optimistic? Not if you look at free cash flow margins and uses of capital
The S&P 500 of the 1990s before the tech bubble burst looks nothing like the S&P 500 of today.
The technology and healthcare sectors now account for more than 40% of the market cap and earnings—more than double that of 30 years ago. The market also has higher margins, a smaller share of asset-heavy businesses and higher earnings stability than it did back then.
While the increasing weight of these sectors has led to higher FCF margins for the broad market, the improvement has not been solely due to the index’s changing composition. Much of this margin expansion comes from lower capital investment. Nearly all sectors over the last 25 years have seen margin expansion, as management teams have focused on returns and profits rather than growth at any cost.
Indeed, during the 1990s, management teams, believing growth opportunities were bountiful, overinvested, squandering their earnings on capex for future revenues that never materialized. After the tech bubble burst, companies became more prudent. Today, for every dollar of earnings a company generates, it converts about 100% of that into FCF. This compares to only about 50% from 1990 through 2000.
All this matters because:
- Lower capex has resulted in more cash returned to shareholders in the form of dividends and buybacks. It also means a lower chance of oversupply, greater earnings stability and a lower probability of boom/bust scenarios.
- Higher margins mean higher returns on equity (ROEs). It also means higher growth and ultimately higher dividends. Higher margins are usually indicative of formidable barriers to entry and more stability/sustainability in a company’s cash flow and earnings.
In short, shareholders will receive more cash both today and in the future. Typically, companies and indices that exhibit attributes of better quality and capital allocation decisions garner higher multiples.
Today versus the 1990s
4) Market sentiment—too exuberant? Not if you look at our index.
A well-known characteristic of a bubble is that investor enthusiasm drives up prices, prompting others to pile in for fear of missing out.
To measure market sentiment, we score 10 reliable measures of market sentiment for signs of optimism/pessimism, measured by deviation from their mean, compare them over time and aggregate the result.
Specifically, we look at the below factors.
- Relative Strength Index
- Put/call ratio
- Australian Dollar to Yen rate (AUDJPY) 3-month risk reversal
- Commodities Future Trading Commision (CFTC) e-mini Standard & Poor (S&P) positioning
- American Association of Individual Investors (AAII) Bull/Bear
- Number of the New York Stock Exchange (NYSE) stocks above the 200-day moving average minus the number of stocks below
- A proprietary measure of soft economic data momentum (Think Private Mortgage Insurance and consumer confidence]0 VIX curve (3-1m)
- S&P 3-month volume
Each indicator is z-scored and averaged to create the composite with equal weights.
What we find is persistent exuberance in the late 1990s and right before the Global Financial Crisis.
But today’s levels are far from that.
Market prices today look far from irrational
What do you do with this information?
The best thing you can do in any market environment is to have a plan. First and foremost that means identifying your long-range personal and financial goals. Then review current opportunities to identify those which may suit you.
Right now, as some parts of the market are trading richer than others, we think investors should consider adding exposure to areas that we believe have more room to recover (think: cyclical sectors such as financials, industrials and materials). It’s also worth looking at stocks that are trading inexpensively relative to the market.
Your J.P. Morgan team is available to discuss these and other investing opportunities with you.
1To calculate the ERP, we compare the earnings yield of the stock market (which is just the inverse of the P/E ratio, or Earnings per share (EPS)/Price; you can think about it as the share of earnings you get exposure to for each $1 you invest) to the yield on a 10-year Treasury bond. Put simply, ERP = Earnings yield – 10-year yield
2We take the estimated yield of 5% and subtract the 10-year U.S. Treasury yield of 1.5%.
3Say, in a “taper tantrum” type of shock (for reference, equity markets increased during this period in 2013).