Bubble Talk Misses the Point

Is it a bubble?

Prices for U.S. equities are, broadly speaking, up about a third this year, and many of the hot stocks have doubled and even tripled. Meanwhile, profit growth is modest, GDP growth is milquetoast, and wage growth is DOA. It’s the kind of divergence that brings a host of attention to the market, and leads to the all-too-familiar question: Is this a bubble?

The simple answer is, no, it isn’t. But the reasons why it isn’t are as important for investors to understand as the comforting answer itself, and are in fact far less comforting than the answer.

As much as we like to think the market and economics are corralled by logic and rules, the plain fact is that the market is driven by to a material degree by human irrationality. It goes up too far and too fast, only to fall – too far and too fast. When irrationality drives these impulses to extremes, where valuations become completely unglued from fundamentals, you get bubbles.

What’s happening now, though, isn’t being driven by human irrationality. This market does not feel particularly ebullient. Far from it. Just look at the weak ratings for the cable business channels to get a sense of how little excitement there is around this market. This is not the dot-com boom.

Instead, investors are quite rationally being driven by Fed policy. “The Fed, the BOJ (certainly), the ECB and the BOE are setting the example for global markets,” Pimco’s Bill Gross wrote in his monthly investment letter, “basically telling investors that they have no alternative than to invest in riskier assets or to lever high quality assets.” Investors have gotten this message, and are buying risk assets, including U.S. stocks.

“There remains considerable wariness among investors, lenders, and borrowers,” economist David Levy of the Jerome Levy Forecasting Center wrote in the firm’s November investment letter. “A bubble or bubbles must become enormous and produce vast profits to become a ‘macrobubble,’ and the U.S. economy is nowhere near that yet.”

In fact, Mr. Levy thinks another “macrobubble” isn’t likely for a very long time. The reasons for that, though, should give stock bulls pause. The economy is still digging out from the damage of the last bubble, he says, the financial sector is still contracting rather than expanding its balance sheet, and the global economy remains very fragile (with whiffs of deflation, to boot). All this is creating a situation where “the economy is dependent on zero interest rates and low yields to maintain financial stability and the expansion.”

“Do not confuse this business cycle with the past two cycles,” he wrote.

That said, do equity prices accurately reflect the growth potential?

The simplest gauge of equity value, a straight-forward PE ratio, doesn’t show a market that is unusually out of line. The PE ratio on the S&P 500, based on estimates of next year’s earnings, was at 13.89 when the year began, according to FactSet. It’s at 16.52 now. That’s higher, but it’s not in bubble territory. It’s not where it was during the dot-com boom, for example. On Jan. 1, 2000, the S&P 500′s PE ratio was at 31.28.

However, Mr. Levy told MoneyBeat, that masks the fact that PE ratios have been in something of their own bubble since the mid-1980s. Outside of the last 25 years or so, PE ratios do look rich, he said, and in an environment predicated on 0% interest rates, “things can only get worse. You don’t have a really strong, enduring value story.”

The corporate profit story doesn’t look bright, he said. ”There’s a fallacy of composition.” In other words, corporate profits aren’t being driven by the kinds of factors that lead to long, stable growth (Mr. Levy and his team have a paper on the sources of profits that’s worth your time). The real reason profits plunged in the last recession was because business investment – a key source of profit growth – dried up. That was offset to by government spending. But government spending has receded, and business investment is “still very weak.”

On top of that fragile state of things, the biggest threat to the profit picture, he said, isn’t Fed policy, but conditions in the rest of the world. Mr. Levy thinks deflation is a significant risk, and the odds of something overseas going bad and – for the first time – causing a U.S. recession are a bigger risk than a change in Fed policy. Either way, the enduring problems left from that global bubble that popped in 2008 will continue to hamper growth.

“I would rule out the idea of earnings growing robustly for the next few years,” he said.