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Is the US equity market heading for a bubble?

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By Tom Lee, CFAChief Investment Officer, Equities and Derivatives, Parametric

Minneapolis - Asset bubbles have become a popular topic of discussion among market participants. The massive amount of fiscal and monetary stimulus that the federal government has used to combat the impact of COVID-19 has inflated equity markets and contributed to a speculative environment.

In recent weeks we've witnessed explosive upward price changes in a handful of equities driven by a crowdsourced short squeeze. Grizzled market veterans are starting to draw comparisons with the go-go market of the late 1990s that ended with the tech bubble bursting in 2000. That thought leads many to conclude that the U.S. equity market is in a liquidity-driven bubble that again may not end well for investors.

What defines a market bubble?

Historical asset bubbles have been concentrated in the two asset classes where most investors hold their wealth: equity and real estate. The press commonly defines a bubble as a situation where an asset's price increases significantly in a short period, leaving it vulnerable to a sharp retracement. This type of price behavior will leave the assets trading at a level unsupported by any fundamental valuation method.

What makes identifying a bubble so hard to do in real time is the challenge of measuring fundamental value. After the given security collapses, everyone recognizes that the asset was overpriced and acknowledges the bubble — the definition of Monday-morning quarterbacking.

Another classical observation of bubbles is that they accelerate as the bubble transitions to late stages. The acceleration is driven by regretful investors who missed the initial stages of the trend but eventually capitulate and join it. These late investors are subject to the greatest losses as they buy near the market peak.

What are the signs of a market bubble?

Many market forecasters point to recent price action or problematic valuations and see evidence of a bubble. A commonly referenced example outside of equities is bitcoin, whose price appreciation over the past six months has been dramatic. Valuation is problematic for any cryptocurrency, however, so it may be best to concentrate on more tangible assets, like equities.

If we focus on the U.S. equity market, valuation is again tricky. Legendary investor Warren Buffett prefers a simple ratio known as the Buffett Indicator, which measures aggregate market capitalization relative to GDP to determine the value at any moment. The current Buffett Indicator is at all-time highs, above those reached in 2000. Although Buffett considers the indicator the best single measure of market value at any point in time, he acknowledges that it has limitations. After all, history has taught us that equities can trade at historically rich levels for years. Former Federal Reserve chairman Alan Greenspan made his famous "irrational exuberance" speech in December 1996, more than three years before the equity market hit its peak.

Looking at the broad equity market can also be misleading, since it paints all equities with the same brush. Not all equities experienced the same run-up in price. For example, growth stocks have dramatically outperformed value stocks over the past 10 years. This relative performance has left the Russell 1000 Growth Index with a price to earnings (P/E) ratio1 approaching 36. The P/E ratio for the Russell 1000 Value Index Value Index hovers around a more reasonable 21 — still high, but not at the nosebleed level of its growth counterpart.

The point is that if investors are concerned that we may be in the late stages of a bubble, value stocks can potentially offer more protection than growth stocks based on current valuations.

Bottom line: Many trends in the U.S. equity market are indicative of an asset bubble. However, that doesn't mean the market is going to crash tomorrow. Equities can trade at levels above reasonable estimates of fair value for an extended period. Further, not all equities trade at the same valuations. Investors need to be discerning about how they structure their portfolios. Customized portfolio solutions can help investors navigate challenging market environments.

1. The P/E ratio is the ratio of a company's share price to the company's earnings per share, typically used for valuing companies and to assess whether they are overvalued or undervalued.

Russell 1000 Growth Index is an unmanaged index of U.S. large-cap growth stocks.

Russell 1000 Value Index is an unmanaged index of U.S. large-cap value stocks.