This bubble is different than the bubbles that came before it and needs to be analyzed as such.

The key question is not about investor sentiment, but whether central banks can control the anomalous market they’ve created.

13D Research
13D Research

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The following article was originally published in “What I Learned This Week” on August 10, 2017. To learn more about 13D’s investment research, please visit our website.

Over the past few weeks, debate over whether or not a bubble has formed in U.S. equities has reached a fever pitch — split between bears concerned about record P/E ratios and bulls seeing little evidence of investor euphoria. To our mind, this split misses the key element of risk in today’s U.S. equity market.

The threats markets face today go beyond “irrational exuberance” to the source of today’s equity bubble: financial engineering of all kinds. The key question is not about investor sentiment, but whether central banks understand and can control the anomalous market they’ve created. In our estimation, such faith has now become dangerous.

No doubt, throughout history, irrational exuberance about an asset class has been at the heart of market bubbles, from tulips in the 1600s to speculative bubbles in canals and railways in the 18th and 19th centuries to the more recent dot-com and housing bubbles. Evidence suggests such euphoria is absent today. In a June survey, Northern Trust Asset Management found that 65% of investors believed the U.S. equity market was overvalued, a record high in the survey’s 9-year history.

Yet, looking at U.S. equity values, it is easy to understand the other side. Robert Shiller’s CAPE ratio is above 30, surpassing the reading on Black Tuesday in 1929. Moreover, the median price/revenue ratio of S&P 500 component stocks reached its highest level in history last week, surpassing both the 2000 and 2007 peaks.

Tech-giant stocks illustrate why this debate is no longer relevant to diagnosing the bubble threat. Many have pointed to tech’s exceptional performance as evidence of irrational exuberance. As Managing Director at BK Asset Management, Boris Schlossberg, wrote for CNBC on Tuesday: “In many ways, the FAANG phenomenon is even more dangerous than the Nifty Fifty.” And it’s not hard to understand Schlossberg’s fear. Of the 10 S&P stocks that have added the most value this year, eight are tech stocks. Moreover, short interest in tech giants has plummeted to an all-time low 2% of traded shares, half the S&P average:

However, digging deeper, the market tells a very different story. This week, Hussman Funds released a chart that breaks component stocks in the S&P 500 down into deciles based on price/revenue ratios. Both today and in 2000, tech stocks dominate the highest decile. However, there is a marked difference between then and now. In 2000, the highest decile diverged dramatically from all others as irrational exuberance spread. Today, on the other hand, all deciles have climbed together. As John Hussman writes:

“As of last week, with the exception of the richest decile of stocks, where median valuations were higher only during the January 2000 — March 2001 period (followed by median losses exceeding -80% for those stocks), every decile of S&P 500 components is currently at or within 2% of its most extreme valuation in history.”

Based on fundamentals and outlook for the future, tech giants deserve to lead the market. Moreover, their outperformance is not out of line with the market as a whole, suggesting their relative P/E ratios are by no means irrational by themselves.

Between unprecedented central bank activities — whether QE, NIRP, or ZIRP — financial engineering has flooded the market with capital. Combined with the shrinkage in publicly-listed stocks (WILTW June 29, 2017), the reason P/E ratios are historically elevated is clear — demand is abnormally high at a time when supply is abnormally low.

Put simply, central bank policies have set a new baseline for equity values. Investors are not unresponsive to fundamentals. They are not over-inflating a particular asset, as they did with tulips, railroads, dot-com stocks, and housing. Instead, they are acting rationally according to the standard central banks have set. So the question is, can central banks sustain that standard indefinitely?

The meteoric rise of passive investing suggests how the bubble threat today differs from past bubbles. Central bank engineering has generated unprecedented stability in equity markets, making it more difficult for active investors to find overlooked value, thus easier for algorithmic strategies to outperform. However, as we explored last week (WILTW August 3, 2017), many passive strategies are now pegged to low volatility (which is spiking as we go to print), meaning they count on the artificial stability created by central bank policies. If central banks lose control — whether due to policy normalization or otherwise — it could trigger algorithms to rapidly deleverage and pull down the markets. Investors have shifted to passive for very rational reasons — low fees and a track-record of returns. However, central bank engineering has created a bubble risk nonetheless.

Unprecedented central bank policies mean unprecedented, and potentially unknowable, market threats. In a phone interview on Monday with Bloomberg, DoubleLine’s Jeffrey Gundlach encapsulated this risk: “If you’re waiting for the catalyst to show itself, you’re going to be selling at a lower price.”

Even central banks seem to recognize faith in their omniscience has become dangerously high. As Lena Komileva wrote for the Financial Times this week:

“In a nutshell, central banks are not necessarily turning more hawkish, in defiance of their inflation stability mandates. Rather they are clearly signalling that investors are becoming far too complacent about the policy outlook — and that risks financial stability…This decoupling between economic and financial cycles is where crises are born.”

Talking to USA Today this week, Bespoke Investment Group’s co-founder, Paul Hickey, said: “true bubbles aren’t accompanied by an almost consensus opinion that we’re in a bubble.” While in the past this logic was accurate, central bank policies since the Global Financial Crisis may mean sentiment is no longer a reliable indicator.

And while elevated P/E ratios are not key to understanding the bubble threat, they do suggest why diversification beyond U.S. equity markets is imperative. Evident in Hussman’s chart, few safe havens remain in the U.S. Moreover, historically-extreme valuations mean equities have further to fall in the event of a bubble popping. Search for opportunity outside the U.S. — in markets that have largely not participated in the same dynamics — as the threat that central banks lose control of this engineered and overextended cycle grows more acute by the month.

This article was originally published in “What I Learned This Week” on August 10, 2017. To subscribe to our weekly newsletter, visit 13D.com or find us on Twitter @WhatILearnedTW.

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Navigating complexity in a rapidly-changing world. For more from What I Learned This Week, go to: http://www.13d.com/