'Bubblemania': Market Valuation in Historical Context

Includes: DIA, QQQ, SPY
by: Daniel Zurbrügg

The rapid rise of equity, commodity and energy prices over the last 12 months worries many about a possible renewal of the bubble building process in global financial markets. We don’t share this view for many reasons described in previous newsletters, and we would like to put the current valuations of these markets in a proper historical context.

With the Dow approaching 11,000 points again, it has gained almost 3,000 points in the last 12 months, a gain of 37%. This is a rather impressive number considering the improving but still uncertain outlook for the global economy and the U.S. in particular. We believe that this market is not expensive at all. About 10 years ago, the market was trading around the same level. YES, 10 years ago. It’s been a wasted decade for investors in U.S. equities unless an investor got the timing right and sold in 2000 and then jumped backed in around 2003 and again sold these equity holdings before the crash of 2008.

Even worse, if measured against a basket of major foreign currencies, the value of the Dow is today at around 8,000 points. However, everybody agrees today that market valuations in 2000 were a bubble, like Bob Shiller wrote in his book Irrational Exuberance. Investors commonly refer to P/E (price to earnings ratios) when talking about the relative valuation of equity markets. In the last 80 years, the average P/E for major markets has been around 13.5 but fluctuating significantly around this average.

This is especially true during recessions when the P/E can fall below 10 and in a late phase of a multi-year economic expansion, when these ratios can be above 30. But there are a lot of other factors that need to be considered as well, such as the level of interest rates, the total equity risk premium and the capitalization of the stock market in comparison to the overall production of an economy.

So where do we stand today? The market seems to be fairly valued today by historical standards, but, considering the strong ongoing earnings recovery, we expect P/E ratios to expand and earnings to grow strongly in the next 12-18 months.

We believe that current earnings expectations could prove to be too conservative even if the global economy just experiences continued normalization. Equities seem to offer very good value, considering the record amount of operating leverage, low levels of debt and still very low interest rates.

Even if we get to experience increasing inflationary pressure in the coming years, equities offer at least some protection from inflation, for sure much better than fixed-income papers.

Disclosure: No positions