If you follow the financial press you will have noticed that journalists have grown excessively fond of using the expression “bubble.” They are usually referring to the equity markets, and more specifically to the US stock exchange. After almost nine years of huge gains and impressive profits, this idea is not completely off the mark. The label “bubble” could also be applied to other asset classes such as government bonds or credit investments, as the prices of these investments have also risen massively over the years. Are these supposed bubbles on multiple fronts about to burst?
First, a bit of semantics. An advanced upward trend does not constitute a bubble. The latter is characterized by very strong and accelerating price gains, a decoupling of prices from underlying valuations and, imperatively, high participation by a broad-based public. To anticipate our conclusion: we do not see these symptoms.
For investors, trends are valuable because the likelihood of a trend continuing is greater than that of it reversing. This is helpful to the extent that investing is not a scientifically exact discipline. It is always about estimating the probability of different scenarios. The existence of trends must be explained by human behavioral patterns. Investors, like all people, do not always act rationally, but (fortunately) also emotionally. The prices on the markets are set by the actions of humans. The vast majority of us likes to be in the company of other people; the actions of others have an impact on us. The more people that become infected by a price movement, the stronger the herd instinct becomes and, along with it, the trend. A brief excursus: the increasing importance of model-based quantitative strategies has also not changed this fact substantially. Behind every system there is (still today) a model developer. This person – in response to success and failure – can adjust the parameters of his model at any time and, therefore, cannot avoid being influenced in his decision-making. The technical interim assessment thus says, yes, the trends on the equity markets are well advanced, enabled by central banks and the ultra-expansive monetary policies they have had in place for years. However, there has not been a significant acceleration of the long-term upward trend. The equity market is not accelerating; it is simply expanding at a very robust rate. In addition, the market support is not coming from just a handful of stocks or themes, but is broadly based, which is a sign of high quality.
Are valuations pointing to some tough times ahead? A sober analysis of the situation does not indicate that prices have decoupled from fundamental valuations. Even the US stock market, where many think valuations are stretched, is trading at less than 20 times expected 12-month forward earnings. Conversely, this still equates to an earnings yield of over 5% – irrational valuations would look different. Within the market there are, of course, segments where valuations have broken with reality. But the claim cannot be made that the market in general is too expensive. It is likely that the painful memories that many experienced investors have of the last two major bear markets of 2000–2002 and 2007–2009, with losses of 50%, respectively, have prevented a broad overvaluation of the markets.
The third symptom of a bubble market is nonchalant participation of a broad and increasingly inexperienced public, acting with exuberant carelessness. It is difficult to still insist that this is the most hated bull market of all time (because many people did not participate in it). The days of very easy profits are gone. Investors have in fact increased their positions in risk assets, especially in 2017. But they did not do so to an extent that would indicate a contrarian sell signal. So, when is the point you should begin to have serious concerns about the performance of the stock markets? That would be when there are no longer any warnings that the bubbles will burst. The prudent investor remains invested, adhering to the principle of selective diversification and subjecting investments to rigorous quality control.
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