Elevated Asset Prices: A Boom, a Bubble, and then a Bust?
As yields rise and markets react, financiers grow worrisome that equities are in asset bubble territories. Equity markets, often regarded as a barometer for future economic outlook and an indicator of current conditions, have attained all-time highs while facing the largest economic contraction in the last 80 years. The stock market has experienced a recovery of colossal proportions, creating a divide between skeptic and optimistic financiers.
The argument for equities in asset bubble territory
To a certain extent, assets are priced relative to one another. The stretched equity prices are a result of the fear-of-missing-out and don’t-fight-the-Fed attitudes that have motivated investors to back riskier assets. In light of below zero real interest rates and the Federal Reserve maintaining its current target rate between 0 – 0.25%, there is no alternative for decent returns other than the stock market for investors unable to access private markets. The lower yields offered by bonds put forward little to no competition to those of equities. The relatively higher returns on stocks have all but eliminated the 60/40 portfolio, and the allocation strategy is unlikely to come back while equities remain overweight.
Financial theory and market mechanics have helped investors indulge in overpriced assets. Valuations are a result of the present value of discounted cash flows; when risk-free rates decrease, the present value of future cash flows increases, sending valuations to rise above past estimates. In maintaining low-interest rates, the Fed is providing the fuel for the continuous overpricing of equities – and the formation of an unstable market bubble. This effect is most dramatic with tech stocks. Leading the rally over the last couple of months, tech stocks can be classified as long duration assets because their cash flows project far into the future. In periods of low-interest rates such as the present, the convexity of said assets is higher, making their prices more sensitive to changes in interest rates. Last week’s sudden increase (the yield on the 10-year Treasury surged to a high of 1.54% from 1.39%) and decrease in yields has had a rollercoaster effect on tech stocks. On a cautious note, the speed of the “backup” – a headwind for equity performance – as seen in the past month, should draw investor attention towards more cyclical and shorter duration stock; at least from a fixed income lens. If there is money to be made, this is where investors ought to be.
The Fed’s effect is not limited merely to interest rates. The Fed itself is a market player, albeit in a peculiar and unusual way as it is not profit-seeking. When the Central Bank decides to venture into financial markets, it does so with only one purpose: to provide and extend liquidity. In doing so, it has no interest in determining whether or not assets reflect their fair value and this inherently fuels inflated prices. As stated by prominent investor Howard Marks in his memo to Oaktree Clients, “This orientation suggests [that the Fed] has no aversion to prices that overstate financial reality.” Through its promise to continue to purchase bonds, the Federal Reserve is indirectly placing money at the disposal of sellers, who in turn put that capital to use in the form of reinvestment. This additional influx of capital and demand for investment opportunities also adds to the rising stock prices; despite such inflation, the central bank has assured investors that it would not run out of ammunition and continue to purchase securities, attempting to provide liquidity and assist economic recovery.
The Fed’s asset purchases also raise investment-grade bond prices, creating enough room for high-yield bonds to rise as well. When compared to the low returns provided by investment-grade bonds, high-yield bonds become more attractive, further driving up the cost of risky assets. As a result, credit markets become a little more unstable, investment-grade doesn’t look as enticing as high yield, highly leveraged, hazy companies. Irrational exuberance, the stamp of asset bubbles, whereby investors crowd an asset class driving up demand, is apparent. Concurrently, prices rise beyond any real sustainable value.
Due to the actions of the central bank, the stock market bubble is rapidly inflating; valuations are high and investors continue to flock to equities. A market bubble occurs when stock prices increase dramatically within a short period of time, as seen when equity prices reached all-time highs amidst ongoing economic struggle and financial strife caused by COVID-19. The health crisis remains, and yet stock prices are discounting for an unknown supposedly near “covid free” future. At the current global vaccination rate (6,074,932 doses daily), it will take approximately 5.1 years to immunize 75% of the human population with a two-dose vaccine.
Although such behaviour seems fundamentally irrational, behavioural finance can lend some explanation to the patterns behind the rally. As markets rise, it becomes easier for investors to rationalize its momentum, and to find a reason to believe in the rally. Access to capital and the fear of missing out only accentuate the rally. As the Fed provides support and leads the way to economic recovery, investors grow more confident in its ability to sustain the high market levels it induced. With confidence in ongoing liquidity and herd-like market optimism, the fundamental argument behind valuations slowly vanishes. The optimism only grows as vaccine distributions exhibit progress and investors begin looking past the pandemic. Overall, it appears that most investors agree that the powerful Fed can keep assets inflated and that overall, the pandemic is “nearly” over. According to Bloomberg’s Vaccine Tracker, it will take an estimated 10 months before the US can enable a return to normalcy, delays and natural disasters (storms) excluded.
Many active managers and funds are “benchmark huggers” who simply change the weights of certain favoured stocks in an attempt to beat the market and satisfy their target returns. Adding to this magnitude is the demand behind certain names as institutional money managers match their portfolios to their respective benchmarks. If a certain stock takes off and portfolio managers do not hold a proportional weight to that of their benchmark, they will underperform by a considerable amount, something investors paying extensive fees will strongly dislike. Risk aversion falls behind risk-seeking when investment-grade no longer provides enough to meet the needed target return. As said by renowned economist John Maynard Keynes, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Perhaps the fear of missing out has overpowered the fear of losing money in risky investments normally haunting the professional money manager.
The elevated prices, abundant, liquidity, and low-interest rates create the perfect combination for an eventual pop, likely not to end well. The built-in optimism, resulting in favourable expectations are vigorously diminishing the potential negatives. In combining both the inflow of liquidity and low-interest rates, firms have now an opportunity to access capital at extraordinarily low costs, giving rise to increasing leverage taken on by many firms and states alike. As long as companies have easy access to capital, even those with failing strategies, bad business models, and inadequate management have the capacity to borrow and refinance debt long enough to remain solvent and narrowly evade bankruptcy. There are dangers to large amounts of leverage, the instability it brings and the chaos that ensues is worrisome.
The argument against a growing asset bubble
A prerequisite to obtaining your undergraduate or graduate degree in finance is mastering the Efficient Market Hypothesis (EMH). A cornerstone to modern financial theory, the EMH hypothesizes that stocks trade at their fair market value, and prices reflect all material information. The theory thus proposes that current asset prices ought to reflect positive underlying factors: strong cash flows, strong earnings, strong growth prospects, and a strong economic outlook.
On strong cashflows and earnings.
Tech valuations can be rationalized and justified. The pandemic has been good to the FAANG. The adoption of technology combined with the ease with which business can be scaled has been massively favourable for the FAANG. Tech stocks company balance sheets are flush with cash! Apple reported its largest earning quarter yet last month, it had for the first time in its history grossed more than $100 billion in a single quarter. Facebook also beat its earnings reporting $3.88 per share versus the $3.22 per share forecasted by Refinitiv. The pandemic has fueled the adoption of technology and tech gadgets. The fast adoption of e-commerce, virtual meetings, cloud computing, and virtual entertainment have shed light on the massive potential that technology-driven companies can unlock.
For instance, movie studios have seen the massive profits that can be generated from online movie releases. Comcast’s Trolls World Tour generated $100 million in digital revenues for Universal Studios. Of those sales, Universal pocketed $77 million, a much larger profit margin than would have been possible with an equivalent ticket sales revenue pre-pandemic. To contextualize, Universal studios yielded lower income on the original movie despite generating larger ticket sales volumes. To capture an amount close to $77 million in net income, Universal would have had to sell a multiple of $100 million in ticket sales at the box-office. Netflix ended Q2 of 2020 with nearly 200 million subscribers, an increase of 10 million additional subscribers. May to June also saw Disney+ reach the company’s 60 million subscriber objective four years ahead of schedule.
On strong growth prospects
The amplified dependence on technological devices and online platforms for entertainment, social connection, education, and labour needs has propelled the tech industry years forward. Post pandemic, emerging countries provide immense opportunities in the adoption of tech goods and services, creating a significantly large pool of potential consumers. Many emerging markets remain untapped, in India alone the number of smartphone users is expected to reach over 820 million by next year. The potential for larger profit growth opportunities warrants the high valuation prices of some of these stocks. As long as they continue to push for growth, their valuations merit a certain degree of justification. According to GSMA, approximately 67.04% of the world carries a mobile device with abundant internet connectivity at the tip of their fingers. Put differently, from a conservative viewpoint there is potentially at minimum 10% of the world that will in the coming years consume ads and generate advertising revenue for the likes of Facebook or subscribe to services of companies such as Netflix.
On a strong economic outlook
The business cycle argument suggests that the very short-lived recession has led the way to a new booming cycle! The rationalization behind this thesis is that a new cycle brings about new growth and economic expansion. The economic boom theory provides a defense to new all-time highs and sound motive to invest in buoyant asset prices with the expectation to reap returns as the economy moves further along its cycle. There is reason to be cautious, this new cycle is unlike any other, it was not caused by the amalgamation of economic weakness but rather enforced by shutdowns and resulted in a recession. There was no growing underlying weakness birthing the recession, the previous cycle was good, economically, the world was doing well.
For the reasons set out, there is justification to be found and argued in favour of the elevated prices. As tech stocks compose a large majority of many indexes its mechanical effect is to bring the rest of the market up with it. Nearly 55% of the increase in the S&P 500’s market value in the past year was on account of the gains experienced in the information and technology sectors. From an investor’s point of view, if the earnings of a company are expected to grow at an above-average rate compared to industry peers or the market as a whole, then purchasing shares at a steeper multiple is warranted. That is, investors, pay for what they believe a company can potentially achieve in the future, if the prospects of growth seem quite high, then a high price tag might seem attractive in comparison. In many ways, investing has a lot to do with perspective and intrinsic beliefs. Bridgewater Associates estimates that only about 5% of the top 1000 American companies are in bubble territory, and these stocks consist of mostly emerging tech firms that are small in size and have not yet shown signs of sustainable profitability with high levels of probability. Overall, if these prices do collapse it is unlikely to take the entire S&P and broader financial market down with it.
Concluding thoughts
The new cycle offers growth but how much and for how long? It is unlikely to last for an extended period given the massive leveraging and the high probabilities that this will all end in widespread bankruptcies. How much debt can central banks take on before it’s too much? All of these questions pose severe issues, and this is without accounting for the effects of inflation. This cycle will likely be a short one. However, the market as a whole is not in asset bubble territory; certain stocks, specifically the ones with attractive narratives and stories, are at risk of severe valuation corrections. As seen by yesterday’s market reaction to the 1.5 percent increase in 10-year yields, high growth companies with “good enough” stories, for which investors were overpaying on their ability to change the world, are now rapidly adjusting to reality (Tesla shares dropped roughly 5% and the NASDAQ composite fell by 10%). Perhaps investors have not learned from the late dot.com bubble; investments should not be made purely on world-changing innovative ideas but along with it, on tangible strong cash flows. In addition to easy access to liquidity, the over-optimism, hype, and perception that these business models need not follow tried and true financial criteria for success will be investors’ fatal flaw.