Bubble deniers abound to dismiss valuation metrics one by one

New York

EVERYWHERE you look, there's a valuation lens that makes stocks look frothy. Also everywhere you look is someone saying don't worry about it.

The so-called Buffett Indicator. Tobin's Q. The S&P 500's forward P/E. These and others show the market at stretched levels, sometimes extremely so. Yet many market-watchers argue they can be ignored, because this time really is different. The rationale? Everything from Federal Reserve largesse to vaccines promising a quick recovery.

How convinced should anyone be when dismissing the message of metrics like these? To be sure, both the market and economy are in uncharted waters. It's possible - perhaps likely - that old standards don't apply when something as random as a virus is behind the stress. At the same time, many a portfolio has been squandered through complacency. Market veterans always warn of fortunes lost by investors who became seduced by talk of new rules and paradigms.

"Every time markets hit new highs, every time markets get frothy, there are always some talking heads that argue: 'It's different'," said Don Calcagni, chief investment officer of Mercer Advisors. "We just know from centuries of market history that that can't happen in perpetuity. It's just the delusion of crowds, people get excited. We want to believe."

Robert Shiller is no apologist. The Yale University professor is famous in investing circles for unpopular valuation warnings that came true during the dotcom and housing bubbles. One tool on which he based the calls is his cyclically adjusted price-earnings ratio that includes the last 10 years of earnings.

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While it's flashing warnings again, not even Mr Shiller is sure he buys it. At 35, the CAPE is at its highest since the early 2000s. If that period of exuberance is excluded, it clocks in at its highest-ever reading. Yet in a recent post, Mr Shiller wrote that "with interest rates low and likely to stay there, equities will continue to look attractive, particularly when compared to bonds".

Another indicator raising eyebrows is called Tobin's Q. The ratio - which was developed in 1969 by Nobel Prize-winning economist James Tobin - compares market value to the adjusted net worth of companies. It's showing a reading just shy of a peak reached in 2000. To Ned Davis, it's a valuation chart worth being wary about. Still, while the indicator is roughly 40 per cent above its long-term trend, "there may be an upward bias on the ratio from technological change in the economy", wrote the Wall Street veteran who founded his namesake firm.

Persuasive arguments also exist for discounting the signal sent by the "Buffett Indicator", a ratio of the total market capitalisation of US stocks divided by gross domestic product. While it recently reached its highest-ever reading above its long-term trend, the methodology fails to take into consideration that companies are more profitable than they've ever been, according to Jeff Schulze, investment strategist at ClearBridge Investments. "It's looked extended really for the past decade, yet you've had one of the best bull markets in US history," he said. "That's going to continue to be a metric that does not adequately capture the market's potential."

At Goldman Sachs Group, strategists argue that however high P/Es are, the absence of significant leverage outside the private sector or a late-cycle economic boom points to low risk of an imminent bubble burst. While people are shovelling money into stocks at rates that have signalled exuberance in the past, risk appetite is rebounding after a prolonged period of aversion, according to the strategists, who also cite low interest rates.

"Today is a very different situation - I don't think we've got a broad bubble," Peter Oppenheimer, chief global equity strategist at the firm, said in a recent interview on Bloomberg Television. "Given the level of real rates, where they are, it's still likely to be broadly supportive for equities versus bonds."

Another rationale employed to dismiss certain valuation metrics is the earnings cycle. Corporate America is just emerging from a recession, with profits forecast to stage a strong comeback. The strong outlook for profits is why many investors are giving similarly stretched valuations the benefit of the doubt. Trading at 32 times reported earnings, the S&P 500 looks quite expensive, but with income forecast to jump 24 per cent to US$173 a share this year, the multiple drops to about 23.

The valuation case becomes more favourable should business leaders continue to blow past expectations. For instance, if this year's earnings come in at 16 per cent above analyst estimates, as they did for the previous quarter, that'd imply a price-earnings ratio of less than 20. While that exceeds the five-year average of 18, Ed Yardeni is not troubled by what he calls "the New Abnormal". "Valuation multiples are likely to remain elevated around current elevated levels because fiscal and monetary policies continue to flood the financial markets with so much free money," said the founder of Yardeni Research Inc. He predicts the S&P 500 will finish the year at 4,300, about an 8 per cent gain from current levels.

Still, it's hard to ignore the risks to underlying assumptions. While rock-bottom rates underpin many of the arguments, this year has shown that the Fed still is willing to let longer-term interest rates run higher. And betting on huge upside earnings surprises is risky too - it's rare to see a 16 per cent beat historically. Before last year, earnings had exceeded estimates by an average 3 per cent a quarter since 2015.

"This happens in every bubble," said Bill Callahan, an investment strategist at Schroders. "It's: 'Don't think about the traditional value metrics, we have a new one'. It's: 'Imagine if everyone did XYZ, how big this company could be'."

Valuations are never useful market-timing tools because expensive stocks can get more expensive, as was the case during the Internet bubble. Yet viewed through a long-term lens, valuations do matter. That is, the more over-valued the market is, the lower the future returns. According to a study by Bank of America strategists led by Savita Subramanian, things like price-earnings ratios could explain 80 per cent of the S&P 500's returns during the subsequent 10 years. The current valuation framework implies an increase of just 2 per cent a year over the next decade, their model shows. BLOOMBERG