- Earnings have been growing in the last 12 months, but haven’t grown that much over the last 20 years.
- Even the Swiss central bank owns almost $3 billion worth of Apple’s stock.
- After the dot-com and the housing bubbles, school books will talk about the central bank bubble in the future.
All we see right now is the stock market continuing to go up. The S&P 500 is already up 9.7% year to date, and there is no sign that the trend might weaken or reverse. Over the last 8 and a half years, the index is up 242%.
Figure 1: S&P 500 since March 2009. Source: FRED.
When you see an asset—or even worse, a basket of assets—perform in such a remarkable way over time, the logical question to ask is whether the stock market is in a bubble.
In order to assess whether it is in a bubble, we first have to define what a stock market bubble is.
Stock Market Bubble
A stock market bubble is when stock prices are irrational in relation to their actual business fundamentals. The best measure for business fundamentals is earnings, so let’s see if earnings have been growing lately.
Figure 2: S&P 500 earnings in the last 12 months have been rising (even more in the last quarter). Source: Multpl.
Reported earnings have increased 14% in the last 12 months, and the S&P 500 has increased exactly 13.5% in the same period. Thus, this shouldn’t be categorized as a bubble.
This is an easy story to sell: earnings are increasing and thus, so are stocks. The fact is that the majority of investors agree with that notion. Nevertheless, I always like to look for different opinions and one can always be found with Nobel prize winner and behavioral economist, Robert Shiller.
Figure 3: Robert Shiller, Nobel prize winner and Yale University finance professor. Source: AZQuotes.
In addition to the quote above, another famous quote of his is the following:
Behavioral finance explains how it’s in our nature to simplify things because we are wired to reach our goals with as little effort as possible. This is especially true for our brain because it consumes lots of energy and therefore the less you use it, the better from an evolutionary perspective, of course. Nevertheless, such principles, and what Shiller’s famous quotes say, can be easily applied to current markets.
If we just use a bit more data to look at S&P 500 earnings, we can see that the situation is far from positive and the circulating story might be that earnings are rising but the truth is the opposite.
Figure 4: S&P 500 earnings in the last 20 years. Source: Multpl.
The first thing to note is that current S&P 500 earnings are below 2013, 2014, and 2015 earnings. Consequently, we can’t talk about earnings growth, but we can talk about a bubble. On top of this, current S&P 500 earnings are equal to 2007 earnings. So to be precise, the S&P 500 hasn’t actually seen earnings growth for a decade now. Additionally, these earnings are nominal and adjusting for the 15.4% cumulative inflation in the last 10 years shows how real S&P 500 earnings have declined significantly.
If I compare current earnings with inflation adjusted 1997 S&P 500 earnings, then the actual earnings growth rate for the S&P 500 over the last 20 years would be 6.5%. That’s not per year, that’s cumulative over 20 years.
Another thing to add is the S&P 500 survivorship bias as the companies with low earnings lead to lower stock prices, and market capitalizations are excluded from the S&P 500 index, thus S&P 500 earnings are a positively skewed metric.
So we can conclude then that stocks are in a bubble as earnings haven’t been growing for the past 20 years. Thus, stock prices are irrational. Now the question is, what is pushing stock prices higher and how should an investor go about dealing with it?
Factors Creating This Stock Market Bubble
The answer to what’s pushing stock prices higher is pretty straightforward. Central banks continue to put liquidity into the system which has translated into higher asset prices and has created an irrational environment.
Figure 5: Global central banks interest rates. Source: global-rates.com.
Out of the 26 central banks’ interest rates listed above, two—the Swedish and Swiss interest rates—are below zero, the European and Japanese interest rates are at zero, and 7 countries have interest rates below 1%. With interest rates, the situation is already irrational and unsustainable when interest rates are below inflation, thus the U.S. interest rate at 1.25% is still a stimulating interest rate.
On top of the low interest rates, central banks print money and invest it into not only treasuries, but also stocks and bonds. Just to deviate from the typical FED, ECB, and BOJ examples, it’s interesting to note that the Swiss central bank has $750 billion in stocks, bonds, and cash with 20% of that being in stocks.
Figure 6: Top Swiss central bank stock holdings. Source: Wall Street Journal.
Thus if you have a market player that can print money and is buying stocks with that money, it’s a clear sign that the market is totally irrational and in a bubble. In the future, this bubble will probably be called the “Central Bank Bubble.”
How Should Investors Behave?
The fact that the stock market is in a bubble doesn’t mean much. With central banks continuing to print money and buying global assets, the stock market could continue to go higher for decades. Therefore, we have to look at what could be the factor that could change the above described situation.
The only thing that could change central banks’ behavior is inflation. We—and by “we,” I mean investors—have been blessed with a prolonged period of low interest rates in combination with increased global competition, technology developments, and low commodity prices that have kept inflation low. This has allowed central banks to keep interest rates low and stimulate stock and debt markets.
Now, the inflection point will happen when inflation actually starts to significantly increase as central banks will be forced to reverse what they’ve done up until now and this could be very painful for the markets. However, to avoid such painful consequences, central banks could let inflation loose and therefore the best investment in this environment is one that takes advantage of current central bank activity and gives protection from inflation. Such investments are certainly stocks, especially stocks of specific sectors, so continue reading Investiv Daily as I’m always discussing the best low risk, high reward investments out there.