Mid-Year Market Commentary

Posted by Team HFM on July 01, 2014

Investors and market prognosticators seem to be fixated on the concern that there is or soon will be a bubble in the financial markets.  We don’t find that surprising since both of the last two bear markets were caused by the bursting of bubbles, the technology market in 2000 and the housing market in 2008.  The S&P 500 trading at or near its all time high and bond market yields approaching lows not seen in decades only exacerbate these concerns.

Yet if you stop to think about it, “all-time highs” cannot be the definition of a bubble since the market would drop every time it hit the previous high and there would never be any long-term market growth.  So what is a bubble?  Generally it is a situation in which a crowd becomes so fixated on something that their willingness to pay for it becomes divorced from economic reality.  Remember beanie babies?  They are a great example.

In the equity market the economic reality is not based on the absolute price of stocks, rather it is based on how much you are paying for each dollar that a company is expected to earn.  Historically investors in S&P 500 stocks have paid an average of $17 for each dollar a company earns.  Although 17 is the average, that ratio between market price and earnings has varied significantly from under 10 to over 30 during the past few decades.  Currently the average S&P 500 company is trading at 17.9 times its earnings, not too far from the average.  This linkage between earnings and stock prices and the historic growth in corporate earnings are what allow the market to reasonably trade at higher highs.

When that linkage breaks down, there is trouble.  During the technology bubble, investors threw caution to the wind and were willing to pay over 100 times earnings for several of the technology companies.  It finally dawned on investors that those prices were unreasonably high and the bubble burst.  (Often in bubbles, as in the technology bubble, it is not obvious what causes investors to come to their senses.  Never-the-less they do and the bubble bursts.)

A discussion of the bond market is more difficult.  Clearly yields on bonds are lower than, as investors, we would like them to be.  Also we believe that over time bond yields will rise, causing prices to come down and returns to suffer.  But just because we believe that yields are unattractive, does not mean we believe that there is a bubble in the bond market.  Bond yields are, in part, based on inflation and economic growth because investors expect that their investment dollars will be able to buy more in the future than they can buy now.  Otherwise why invest?  Just buy now.  So, if inflation is high, bond yields will have to be high to keep up with the rising cost of goods.  Right now, inflation is not high, at least based on the way the government measures inflation.  Economic growth is not high either, in fact it is quite anemic and unlikely to cause inflation to rise.  Thus bond yields are appropriately low, maybe a little too low, but not bubble low.  Our expectation that yields will rise over time is based on an optimism that economic growth will pick up in the (vaguely undefined) future.

Our conclusion is that there is not currently a bubble in the financial markets.  Consequently we believe it is reasonable to be taking normal investment risks by keeping portfolios fully invested in their planned allocations.