asset allocation | september 28, 2020
Wall Street Versus Main Street: Are Stocks in a Bubble
The stock market seems disconnected from the dire economic environment, but our Head of Global Multi-Asset Sébastien Page does not believe that stocks are in a bubble.
Head of Global Multi-Asset
Stock prices are based on anticipated earnings—not current conditions—and interest rates have fallen meaningfully, which justifies higher valuations.
Unprecedented massive stimulus measures are supporting markets, and in our view the economy seems to be closely following the path of the 2009 recovery.
The stock market looks divorced from the real economy. Does this mean that stocks are in a bubble? I don’t think so. There is significant pain in the real economy—2020 U.S. GDP expected at -8%, 2020 earnings -23%, unemployment 10%, 20 million people unemployed. How can the stock market be up 55% from the bottom?
The simple answer is that stocks don’t price in current conditions. They anticipate future earnings. Also, we need some perspective on this 55% number. The S&P 500 is only up 6% year-to-date and the Russell Value Index is down 10% year-to-date. Only 38% of the S&P 500 is making new highs relative to pre-pandemic levels. Also the S&P doesn’t represent the entire economy, it represents 500 large companies, some of which have digital business models that have thrived during COVID.
So, I don’t think stocks are in a bubble for four reasons. First, earnings are temporarily depressed, including some companies losing money. Markets are trading off 2021 and beyond earnings. Stocks don’t price off current economic conditions. They price off anticipated conditions and anticipated earnings.
Second, rates have come down 150 basis points, which justifies higher valuations by discounting the cash flows. Third, the size of the stimulus has been unprecedented, representing as much as 40/45% of total world market cap.
If we adjust for the level of rates, we are actually following the path of the 2009 recovery quite closely. There are two stages to a recovery: first, multiples expand because earnings are depressed, and second, earnings renormalize.
By the way, on the disruptors, these are extremely profitable companies with highly scalable business models. There is some speculative buying in the market, but look at the disruptors’ cash flow yield and subtract the risk free rate, and you’ll find that they look fairly cheap—especially relative to the tech bubble of 2000.
So, no we are not in a bubble, stocks are perhaps fully priced. At the moment, we are neutral between stocks and bonds from a tactical six-18 month horizon perspective.
A basis point is 0.01 percentage point.
* -23% 2020 earnings is the median between the Yardeni forecast and consensus estimate as of 8/24/2020.
Source: Yardeni Research, INC. https://www.yardeni.com/pub/yriearningsforecast.pdf
* Stock market is 55% from the bottom is based on the S&P 500 Index, from 3/23/2020, as of 8/25/2020.
Source: S&P 500 Index, Bloomberg Finance L.P. Total Return Analysis (TRA).
* S&P 500 is only up 6% year-to-date is based on S&P 500 Index, from 12/31/2019, as of 8/24/2020.
Source: Bloomberg Finance L.P., Price index appreciation.
* Russell Value Index is down 10% year-to-date is based on Russell 1000 Value Index as of 8/26/2020.
Source: Bloomberg Finance L.P. TRA.
* 38% of the S&P 500 is making new highs relative to pre-pandemic levels is based on S&P 500 Index as of 8/18/2020.
Sources: FactSet, CNBC.
* Stimulus representing +40% of the world market cap represents global stimulus and includes both monetary and fiscal measures.
Sources: Stimulus from Cornerstone Macro, as of 6/17/2020, and MSCI ACWI IMI Market Cap from FactSet, as of 6/22/2020.
Note: Frank Russell Company (Russell) is the source and owner of the Russell index data contained or reflected in these materials and all trademarks and copyrights related thereto. Russell® is a registered trademark of Russell. Russell is not responsible for the formatting or configuration of these materials or for any inaccuracy in T. Rowe Price Associates’ presentation thereof.
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