Are we currently seeing formation of a bubble, or even a bubble peak, following the past four month’s rally? Indeed, over the period, despite the slew of bad news, the S&P 500 experienced just two slight consolidations. Could the sell-off of the past few days not be the first signs of a deeper downtrend on a 6-month horizon?
Many investors have asked us whether we believed in the formation of a bubble, or even a bubble peak, following the past four month’s rally. Indeed, over the period, despite the slew of bad news (increased bottlenecks during the summer, energy crisis, global inflation and global inflation surprises, marked concerns about China, tightening of the Fed’s stance, surging contaminations and the Omicron variant), the S&P 500 experienced just two slight consolidations (-5.2% in September-October and -4% in November-December). Could the sell-off of the past few days not be the first signs of a deeper downtrend on a 6-month horizon?
We do not believe so, even though risk-adjusted performance will obviously be weaker than in 2021 and especially than in the past 21 months. US investors’ positioning remains aggressive and our structural indicator of appetite for risk remains high even though it has weakened slightly recently. (Plus, we should also keep in mind that since 23 March 2020 we have seen the strongest post-bear market bull market since 1945).
However, there are reasons to be cautious:
First, absolute valuations, do look high with significant standard deviations from the historical average. Based on this metric, the US market is clearly expensive though maybe not in a bubble.
Secondly, with the uptick in bond yields and significant acceleration of equity markets, the equity risk premium has contracted. Yet it is significantly above the average for the past 35 years and much higher than in 1998-2000.
Thirdly, in “bubble” periods, stocks representing technological innovation fuel most of the upturn, thus outperforming more ‘traditional’ stocks. That is what we saw in the late 1990s. In fact, this feature is not particularly present today. True, Tech stocks have contributed strongly to the performance of the S&P 500. However, this merely reflects their increased weight in indices. Based on the Advance/Decline Line (which measures the difference between the number of stocks rising and those declining), there is no anomaly, unlike in the late 1990s when the index was rising, while the Advance/Decline line was declining. Likewise, there is no major difference between the free-float-weighted index and the equally-weighted index.
To sum up, speaking of an equity market bubble is therefore not useful and is a source of confusion. There are probably partial bubbles in micro-segments, but we cannot as such say that there is a generalised equity market bubble. We remain long global equities for a strategic horizon (six months) for the previously stated reasons:
- Global economic recovery in Q2 after a sluggish Q1
- EPS forecasts slightly higher than analysts’ projections in the US/Europe
- Positive risk premium
- Cash reserves of financial and non-financial agents
- Central banks’ monetary policy tightening increasingly priced in