When is a bubble a bubble? The Oxford English Dictionary defines a bubble as “a significant, usually rapid, increase in asset prices that is soon followed by a collapse in prices… typically arises from speculation or enthusiasm rather than intrinsic increases in value.”
The question is vital right now, for one of the best guides to the value of shares traded in the United States, the Case Shiller Cyclically Adjusted Price Earnings ratio, CAPE for short, which smooths the ratio of share prices to their earnings, is now at 29.3 as reported by GuruFocus Stock Research. That is 75.4 per cent higher than the historical mean of 16.7. Leaving out the smoothing effect of cyclical adjustment and using the present p/e for the S&P 500, which is 26, the market is still floating where the air is rare and the fall to earth will be long and steep.
The Case Shiller p/e is a meaningful ratio. When it is very low, as it was in the first quarter of 2009 at 13.3 when the market had crashed more than 50 per cent from its 2007 peak, it was a good time to buy. Now, with the CAPE more than twice as high, it is arguably a good time to sell. Clearly, the market has a different view, for stocks are rising as I write this story.
Bubbles are psychological indicators of investor mood. They show enthusiasm, not value of underlying assets. For example, the present Toronto real estate market has surged more than 20 per cent in the last year, the fastest pace in the last 30 years. This is good for existing owners who can use their inflated house prices to sell, then move up to fancier digs with even bigger mortgages. The property bubble is a benefit to real estate agents as well.
Price and intrinsic value get separated when bubbles expand. The fall to earth is even more dramatic than the inflation of the bubbles. In mid-October, 1987, major indexes of market value in the U.S. fell more than 30 per cent. That led down of all world major market. By October 19, the Dow Jones Industrial Average had fallen 23.6 per cent, Hong Kong’s Index was down 45.8 per cent, the worst show on the planet. Many villains were identified including computer trading, then a novel concept that later led to day trading by amateurs, use of derivatives — also a factor in the 2008 disaster, lack of bids for stock offered — a sure sign of fear, trade deficits and sheer overvaluation.
The essential question we have to ask now is whether the present valuation of the market — and it does not matter if you look at Toronto or New York or Hong Kong, Paris or London — reflects reasonable expectation of good business or it is just investor enthusiasm with cash taken out of bonds that are now falling in price. Note that that the total value of bonds is many times larger than that of stock, though no one knows how much larger given that most bonds issued seldom or sometimes never trade and that there is no central price board as there is for stocks on the TSX or the NASDAQ.
Building a bubble
There are many tales of past bubbles that show, in retrospect, how foolish investors can be. The most famous is the Dutch tulip bubble that popped in 1637, ruining many investors late to the game who sold their homes to buy tulip bulbs. They ignored the supply side of the equation. Tulips can make more of themselves, after all. The South Seas Bubble of 1720 was a collection of wacky schemes to import walnut trees to England from Virginia, to improve fishing off the coast of Greenland by unspecified means, and “a company for carrying on an undertaking of great advantage, but nobody to know what it is.”
Think back to Alberta blind pools a few decades ago in investors tossed money into pools with no knowledge of how it would be used. Think of the Dot Com bubble from 1998 to 2000 when anything with a dot in the name flew and you realize that history has no monopoly on hope in excess of reality.
Back in 1998, a company that wanted to publish classified ads online with a bit of editorial content in fields like “used laboratory glassware,” VerticalNet.com, saw its stock value rise to 800 times estimated earnings per share. Some companies with no earnings, no e in the p/e equation, were high fliers. Sense went out the window because buyers did not know what they were buying. Bank stocks, old hat, fell as the newfangled stocks soared. We know the rest.
So we come back to the present level of major U.S. and Canadian stock markets. It looks like a bubble, but is it? Earnings of banks are strong and falling interest rates should expand the difference between what they have to pay for money to lend, which seldom rises much, and what they loan it for, which rises quickly. Life insurance companies can price their products more attractively when cash in their accounts earns more in bonds paying higher interest rates.
So is the run up in stock prices now a genuine bubble?
How big as a bubble?
A study by William Goetzmann of the Yale School of Management reviews 21 stock markets since 1900. Professor Goetzmann defines bubble as a doubling of market average stock value followed by a 50 per cent fall. So an index rise from 100 to 200 is a doubling and the 50 per cent fall brings it back to 100. On that basis, a doubling in just one year happened just two per cent of the time and a 50 per cent fall in the next year happened only in Austria in 1923-24, in Argentina in 1976-77 and Poland in 1993-94.
You could say the 100 per cent rise followed by a 50 per cent fall is too perfect. If we loosen the standard for what is a bubble, then there are more cases of ups not followed by a big down.
So are we in a bubble now? Every bubble rests on some foundation. Today’s is the humble concept of business as usual. The new Trump administration in the U.S. promises to deregulate business, to make life easier for banks that want to do more business with less capital stuck on their balance sheets and, along the way, to pay even larger bonuses to their senior managers. There are deals with Russia either afoot or denied and import clamps going on Mexican imports. The outlook is clouded by lack of knowledge. Nobody has seen the laws that are going to be changed, but markets in the U.S. and Canada, among others, are flying.
Trump’s populism has no definite plan. The outlook for reduced trade caused by import fences of one sort or another is a negative influence. But business economists in Canada are optimistic nonetheless. BMO Capital Markets, for example, suggested in a February 9, 2017 report that the new administration “will more good than harm for the U.S. economy.”
BMO expects Canadian exports to rise in 2017 and GDP growth to rise two per cent in 2017. BMO discounts a trade war that has been suggested by Canada’s minister of external affairs if the U.S. imposes higher tariffs or renegs on NAFTA. Nobody knows what is to happen, but it is certain that risks are up. There is no reason for stocks to soar. The market run up looks like a bubble, smells like a bubble and probably is a bubble.