Everybody in the stock market is wondering whether there is a bubble or not. Yet, US and world indexes still going up. The Dow Jones, as well as the S&P 500 or other worldwide indexes, has been increasing vertiginously since 2009, reaching the highest levels ever seen, as we can see in the chart below.
Dow Jones Industrial Average
Source: Macro Trends
While the index beats historical maximums, volatility has dropped to historical minimums, as Charlie Bilello notes here, or as we can see by looking the VIX index.
VOLATILITY S&P 500 (^VIX)
Source: Yahoo Finance
With this calmed outlook, some investors are warning that the market is highly overvalued. Crescat Capital, in the third quarterly letter of 2017 argues that “the median price-to-sales ratio for the S&P 500 today is the highest ever by a wide margin” (above 2.5), as well as the price-to-book value, or EV/EBITDA.
In addition to high valuation multiples, margins are “at all-time unsustainable highs”, and the concerning is that when recessions occur, margins drastically reduce. And knowing that corporate debt in the US economy “is at all-time highs relative to GDP”, an eventual recession could cause a great crash.
In a previous post we talked about the three drivers of positive investment returns: growth in revenues, margins improvement and multiples expansions. Based on this analytical framework, we can study the key drivers of a stock market crash too. The probabilities of the occurrence of this event increase when revenues are not going to grow as expected, margins cannot improve more, and valuation multiples are extraordinary high. And paradoxically, this is somewhat the current financial situation.
As Crescat Capital noted, margins are at all time high, and their evolution is mean reversion, so we cannot expect a perpetual expansion of margins, but rather, a reduction. Yet, some may say that this time is different, and they might be right.
Multiples are as well at extremely high levels. One of the main “bubbles indicators”, Shiller’s CAPE, is nearly at the level of 1929, only surpassed by the year 2000. This means that valuations with respect to inflation-adjusted earnings in the last 10 years are relatively high. And must be reminded that, in the past, when the CAPE has achieved these levels, it has preceded a huge and painful crash.
Source: Shiller / Yale
But, what about revenue growth? Global GDP continues growing at low rates, but there are some issues that annoy economists. The economy of the US has been boosting for the last years, and it is likely that the growing cycle could be near to its end. The European Union have some internal risks such as Catalonia crisis, Brexit or political instability that may become negative economic shocks. The other big economy, China, has a debt to GDP ratio of more than 300%, and since the Chinese stock market crash in the summer of 2015, doubts have arisen over the future evolution of this economy due to the credit expansion. Finally, the current financial situation completely manipulated by central banks, mainly in the fixed income market, is a source of uncertainty that can explode in every moment.
Thus, the three key elements that determine the return on equity investments do not show a positive outlook for the following quarters. That doesn’t mean that a market crash is imminent. A new paradigm of higher-than-historical margins and multiples may be developing, and the global economy could still grow some years before entering into a recession. What this analytical framework tells us is just that we must be sceptical about these high valuations and low volatility. As James Rickards says here, “complacency and overconfidence are good leading indicators of an overvalued market set for a correction or worse”. So, maybe, and just maybe, is time to hedge or even to be bearish.