Are we in a Bubble?

A developing consensus view is that the US sharemarket is overvalued, certainly by measures such as the Shiller PE (Price to earnings ratio).  Future low returns can be expected based on this measure.

Of course there is some debate about whether this is a bubble. Time will tell.

An earlier Post did touch on this. Another Post put the recent level of sharemarket volatility into a historical context.

 

Furthermore, the consensus view is that although overvalued the risk of a US recession is low. Generally a recession is needed to trigger a large drop in the value of sharemarkets.

None of the following forward indicators are flashing the risk of a recession: Leading Economic Indicators, ISM Manufacturing New Orders, Initial Unemployment Insurance claims, Durable Goods Order, shape of the yield curve (e.g. are longer dated interest rates lower than short dated interest rates, which is often a precursor to recession) and level of High Yield Credit Spreads.

The consensus view is that the US economy will continue to expand in 2018, now into its third longest period of economic expansion. Over time capacity constraints within the economy will grow further (e.g. falling unemployment) and the US Central Bank, US Federal Reserve (Fed), will continue to raise interest rates as the threat of or higher inflation emerge.

This will result in a “classical” ending to the economic cycle where higher interest rates will result in a slowing of economic activity, resulting in a pick-up in unemployment, followed closely by recession, say late 2019 early 2020. Unfortunately the recession will be felt more heavily on Wall Street (e.g. large share price declines) than Main Street.

This article outlines a paper written by James Montier of GMO. He outlines 4 different types of bubbles:

  1. Fad or mania e.g. dot-com bubble, Roaring 20s, and US Housing market
  2. Intrinsic Bubble e.g. Financials prior to the GFC had inflated earnings
  3. Near Rational bubble – the greater fool market, cynical, and they can keep going as long as the music is playing.
  4. Information Bubble

 

Montier argues we are in a cynical bubble (3 above), noting many professional investors acknowledge the US market is expensive yet remain fully invested even overweight, based on a BofA Merrill Lynch survey.

He agrees with Jeremy Grantham, many of the psychological hallmarks of a Fad and Mania are absent. Grantham has raised the prospect the US sharemarket may be entering a two year “melt-up” period as the next phase of the current “bubble”.

Time will indeed tell.  Nevertheless, the cynical bubble appears consistent with the consensus view above.

 

Mortimer’s article also has some great quotes from John Maynard Keynes, a great investor in his own right.

 

 Please see my Disclosure Statement

 

One thought on “Are we in a Bubble?

  1. Pingback: Risk of Economic Recession and a Inverted Yield Curve | Kiwi Investor Blog

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