Is The U.S. Stock Rally A Bubble?

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Includes: IYE, IYW, OEF, SPY
by: Russ Koesterich, CFA

U.S. stocks are off to one of their best starts in years. Most indices are up 10% year to date, prompting many investors to ask: "Are we in another bubble?"

The answer is no, at least when it comes to equities. Here are three reasons why:

  • Most metrics suggest U.S. stock valuations are at or below their long-term average. U.S. large-cap companies are trading at 2.25x book value and 15x trailing earnings, both valuations below the historical average.
  • Not only are valuations below average, they are well below peaks reached in 2000 and 2007. By way of comparison, U.S. equity markets were trading for 3x book value in 2007 and 5x in 2000.
  • On a relative basis, even after the recent rally, U.S. stocks still look cheap. The earnings yield on the S&P 500 is at a 30-year high relative to the yield available on an investment grade bond index. While this is more a function of bonds being expensive rather than of stocks being particularly cheap, the relative play still favors stocks.

However, while U.S. stock valuations are far from bubble territory, U.S. earnings and book value are both being flattered by a multiyear period of exceptional corporate profitability. In other words, U.S. corporations are experiencing an earnings bubble of sorts. Corporate profits are currently nearly 10% of U.S. gross domestic product, above a 60-year average of 8.2%, as U.S. companies have benefited from the economy's slow-growth recovery. The economy has been growing just fast enough to support companies' topline growth, but just slow enough to keep a lid on firms' wage and interest costs.

The upshot for U.S. stocks: They look more expensive when you consider that earnings aren't likely to levitate at today's levels indefinitely. One valuation metric that reflects this is the Shiller price-to-earnings ratio, which uses a 10-year average of earnings rather than a one-year average. According to this measure, U.S. stocks are trading at 22x real 10-year trailing earnings, vs. a long-term average of around 16.5x. This suggests that while U.S. stocks may still outperform bonds, further gains are likely to be more muted and returns over the long term are unlikely to be in double-digit territory.

The good news is that valuations look much more reasonable outside of the United States. Currently, U.S. stocks trade at a 45% premium, based on a price-to-book calculation, to other developed markets. Emerging markets are cheaper still. As such, for long-term investors, the best opportunities may lie outside the United States and in less extended parts of the U.S. market such as in mega caps, and in the energy and technology sectors.

These asset classes are accessible through the iShares S&P 100 Index Fund (NYSEARCA:OEF), the iShares Dow Jones U.S. Energy Sector Index Fund (NYSEARCA:IYE), and the iShares Dow Jones U.S. Technology Sector Index Fund (NYSEARCA:IYW).

Source: Bloomberg.

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Disclosure: In addition to the normal risks associated with investing, narrowly focused investments typically exhibit higher volatility. The energy sector is cyclical and highly dependent on commodities prices. Companies in this sector may face civil liability from accidents and a risk of loss from terrorism and natural disasters. Technology companies may be subject to severe competition and product obsolescence.