Tag Archives: asset bubble

(Revised) U.S. Stocks Are Not in a Bubble and Here’s Why

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If you take a look at the S&P 500 Stock Index for the past twenty years, you will notice a clear cyclical nature to it- it seems to undergo a cycle about every seven years, with a roughly 5 year period of growth and then a two year period of decline. Five and a half years out of the Great Financial Crisis with the Fed rolling back QE and the S&P index reaching an all time high, some investors are worried that U.S. stocks may be in yet another bubble. In my next two posts, I am going to argue that this is not the case…at least for now.

This weekend I read two interesting documents that have convinced me that it is unlikely we will see a dramatic fall in the S&P anytime soon: JP Morgan’s latest edition of Quarterly Perspectives and BlackRock’s 2014 Investment Outlook. I will split up my argument into three pieces: (1) Peaks in Stock Prices Vs. Peaks in the Output Gap, (2) Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits, (3) The EV/EBITDA to VIX ratio.

1.    Peaks in Stock Prices Vs. Peaks in the Output Gap

One thing that has characterized past asset bubbles is that they generally tend to coincide with peaks in the economic cycle. As we’ve discussed in class, an economy can’t operate above full capacity for long periods of time, so at some point output must fall. In the past, these falls in economic output have occurred at roughly the same time when the stock market fell:

3But as you can see by the graph above, the present case is quite different from the past. The output gap is nowhere near a peak right now, and most would agree that the U.S. economy is still in recovery mode from the financial crisis. This recovery has taken much longer than past recoveries from recessions, and has been characterized by slow initial growth, rising incomes, and slowly falling debt burdens. This slow growth coupled with the current negative output gap is a good sign that the U.S. stock market is not on the cusp of another asset bubble.

2.    Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits

One thing that characterizes practically all asset bubbles is an unjustified surge in stock prices. What I mean by ‘unjustified’ is that people begin to ignore fundamental analysis and start buying up stocks simply because their price is rising, much like what happened during the Tulip-Bulb Craze we read about in Malkiel’s Random Walk Down Wall Street. In contrast, the recent rise in stock price has not been unjustified because stock prices have been rising along with corporate profits:

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This positive trend gives credence to the argument that investors are not simply building ‘Castles In the Air,’ and rather are basing their investments in sound fundamental analysis. Something to watch out for though is the growth rate of corporate profits versus that of stock prices. I would argue that it is somewhat worrisome that the growth rate in profits for the past three years has been smaller than that of stock prices, and could potentially be a sign that the U.S. stock market will be overvalued in the future. For now though, the difference in growth rates is both tolerable and reasonable.

Taking a look at the left side of the graphic above, we also see that the length of the current bull run is just below the average of past bull runs, yet its return has been slightly higher than average. Roughly average returns + a typical duration time further justify the point that the current bull run on U.S. stocks is not forming an asset bubble.

3.    The EV/EBITDA to VIX ratio

The final part of my argument has to do with a common market indicator- the EV/EBITDA ratio- a tool that gives a measures of US corporate valuations, leverage, and investor complacency by dividing enterprise value (EV) by earnings before interest, taxes, depreciation, and amortization (EBITDA). This ratio is then divided by the stock market volatility index in order to measure investor complacency.

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BlackRock’s 2014 Investment Outlook provides a solid interpretation of the above graph:

The ratio of the [the EV/EBITDA and the volatility index] is the key. High valuations combined with low volatility can make for a lethal mix. This market gauge sounded the alarm well before the financial crisis…[Today,] valuations are roughly in line with their two-decade average (and leverage is lower). Yet volatility is hovering just above two-decade lows. The result: The market gauge stands well above its long-term average,
but is far short of its pre-crisis highs.

The main point the above graph and discussion make is that although we may be seeing early signs of the formation of an asset bubble, it is not expected to form in the imminent future. It also gives further weight to the argument that corporate earnings need to start rising faster if the economy is to avoid a bubble in the future because a rise in earnings would drive the EV/EBITDA to VIX ratio down (assuming volatility stays low).

In summary, I have laid out a three-pronged argument for why I think the U.S. stock market is not experiencing an asset bubble. A wide output gap, a close correlation between earnings growth and stock price growth, and a reasonably small EV/EBITDA ratio tells me that the U.S. economy is not on the cusp of another bubble. Furthermore, I am generally in agreement with Ray Dalio’s claims (mentioned in some of my previous posts, here and here; the first post examines the long term debt cycle and the second elaborates on the last stage of the cycle- the reflationary period) when he asserts that we are currently in the reflationary period of the long-term debt cycle. Consequently, I expect the economy to make a full recovery in the next couple of years: QE tapering will continue, interest rates will rise slowly but steadily, and both corporate earnings and income growth rates will rise, further dispelling doubts of a possible bubble. With all this in mind though, I think it’s important to keep a close watch on the indicators I discussed throughout this post because they provide a good summary for the state of the U.S. stock market.

 

 

 

U.S. Stocks Are Not in a Bubble, and Here’s Why (Part 1)

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If you take a look at the S&P 500 Stock Index for the past twenty years, you will notice a clear cyclical nature to it- it seems to undergo a cycle about every seven years, with a roughly 5 year period of growth and then a two year period of decline. As one would expect, it generally falls when the economy undergoes a recession and rises during periods of recovery and growth. Some would argue, Ray Dalio included, that during the past twenty years changes in the S&P have been driven by the short term debt cycle, which is largely controlled by the Fed’s manipulation of interest rates. Low interest rates generally stimulate investment and cause stock prices to rise, while long periods of high interest rates eventually cause stock prices to fall. There are obviously other factors involved, but that’s the general trend. Five and a half years out of the Great Financial Crisis with the Fed rolling back QE and the S&P index reaching an all time high, some investors are worried that U.S. stocks may be in yet another bubble. In my next two posts, I am going to argue that this is not the case…at least for now.

The cycles in the S&P have been something that has interested me for a while, and given that the index is currently at the end of the 5-year growth period that I mentioned earlier, lately I have doubted whether the S&P can sustain its growth for much longer. This weekend I read two interesting documents that have convinced me that it is unlikely we’ll see a dramatic fall in the S&P anytime soon: (1) JP Morgan’s latest edition of Quarterly Perspectives and (2) BlackRock’s 2014 Investment Outlook. I will split up my argument into three pieces: (1) Peaks in Stock Prices Vs. Peaks in the Output Gap, (2) Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits, (3) The EV/EBITDA to VIX ratio.

1.    Peaks in Stock Prices Vs. Peaks in the Output Gap

One thing that has characterized past asset bubbles is that they generally tend to coincide with peaks in the economic cycle. As we’ve discussed in class, an economy can’t operate above full capacity for long periods of time, so at some point output must fall. In the past, these falls in economic output have occurred at roughly the same time as when the stock market fell:

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But as you can see by the graph above, the present case is quite different from the past. The output gap is nowhere near a peak right now, and most would agree that the U.S. economy is still in recovery mode from the financial crisis. This recovery has taken much longer than past recoveries from recessions. If we were to take Dalio’s perspective on the issue, the unusually lengthy recovery could be explained by the idea that the crisis of 2008 was a part of the U.S. long term debt cycle (aka it was a depression rather than a recession, for more on that see one of my previous blog posts) and the U.S. economy is now in the reflationary period characterized by slow initial growth, rising incomes, and slowly falling debt burdens. In any case, the current negative output gap is a good sign that the U.S. stock market is not on the cusp of another asset bubble.

In my next post I will discuss the other two parts of my argument: Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits and The EV/EBITDA ratio.

How to Deflate the Education Bubble

In the last 10 years, outstanding student debt in the United States has grown from $240 billion to an astonishing $1.2 trillion today, driven in part by rapidly accelerating tuition rates.  At the same time, labor demand has stagnated, keeping many graduates from paying down this debt.  In fact, JP Morgan deemed the student loan market so overladen with risk that in October of 2013, the firm stopped issuing any additional student loans.  To me, the student loan market is eerily similar to the housing market before the Great Recession – there are too many bad investments and not enough good ones.  And as was the case in 2008, my fear is that the student loan market is about to crash.

Before examining a solution to the student loan issue, it is important for us to first understand the route cause of asset bubbles.  In A Random Walk Down Wall Street, Burton Malkiel makes the cause of asset bubbles very clear in his explanation of the tulip-bulb craze that plagued Holland in the early 1600s.  After the mosaic virus created “bizarres” (ie: striped tulips) in the late 1500s, Dutch citizens desperately wanted the most unique tulips in their gardens, and they were willing to pay a handsome premium for “bizarre” bulbs.  As more and more people started bidding up the price of  bulbs, hoping they would yield unique flowers, more and more people saw tulip bulbs as a smart investment.  Indeed, by the 1620’s people were selling their jewels, furniture, and even land to buy tulips!  Nevertheless, no bubble can grow forever, and in February 1637, Dutch public opinion changed.  The price of bulbs fell more than 20-fold that month, and despite the government’s best attempt to prevent a sell-off, the bulb bubble burst, leaving an abundance of disappointed and bankrupt investors (Part 1 – Section 3 – “The Tulip-Bulb Craze”)

The Tulip-Bulb craze perfectly illustrates the result of what Malkiel refers to as “Castle-in-the-Air” investment theory.  Under this theory, an investment’s value is based on public opinion, and decisions to buy and sell are based on random guesses about changes in public opinion.  When public opinion changes, bubbles can burst and investors can suffer huge losses.  In my opinion, the “Castle-in-the-Air” investment theory applies perfectly to college education; many people attend college because public opinion dictates it is the “smart” thing to do.  But as I point out in “Why College Graduates are Useless,” data does not confirm this opinion, as many students cannot find jobs, even after investing thousands of dollars in student loans and higher education.  It thus seems that it is simply a matter of time before the student loan market goes the way of Dutch tulips and crashes.

I’d argue, and I think Malkiel would agree, that a switch in investment theory could reduce the risk of asset bubbles.  In addition to “Castle-in-the-Air” theory, Malkiel also explains “Firm-Foundation” theory, which is an investment strategy based on the intrinsic value of one’s investments.  When the price of the investment is less than its intrinsic value, you should buy.  When price is more than intrinsic value, you should sell.  Because this form of investing is based on data and not public opinion, it is arguably less susceptible to speculative attack.  Indeed, Malkiel points out that firm-foundation investing is how Warren Buffet made his fortune.

It therefore seems that to deflate the risk of a student loan bubble, we need to switch investment in higher education from a “Castle-in-the-Air” model to a “Firm-Foundation” Model.  But how?  I believe the answer lies in a recent Wall Street Journal article.  In “Colleges Are Tested by Push to Prove Graduates’ Career Success,” author Melissa Korn points out a trend in prospective students requesting information on graduates’ salaries.  Given that college is an investment (that should generate a real return after an initial payment), this request seems extremely logical!  Indeed, why would anybody spend $200,000 on out-of-state tuition at UM without assurance (or at least data supporting) a sizeable income stream after graduation?

If firms are required to release GAAP-audited financial statements to aid prospective investors, I believe universities should have to do the same.  While there is currently significant push back from universities to release this data, I think that reporting graduate salaries based on school, major, GPA, etc. is an essential step in changing college education from a “Castle-in-the-Air” investment to a “Firm-Foundation” investment (the implications of this are consequential indeed, as it would likely force the cost of high-paying majors like business and engineering higher than the cost of low-paying majors like anthropology and agriculture.  That said, this is a consequence that I am comfortable with).  Personally, I believe if we can successfully alter the way that students choose to invest in college education, we can effectively reduce the risk involved in student loans and prevent student debt from repeating the Dutch Tulip Crisis and pushing America back into recession.