Here is a ‘surprise’ for you. The number of news stories stating that irrational exuberance is back on the stock markets is growing rapidly. In addition, irrational exuberance was mentioned in Bank of America Merrill Lynch’s latest monthly Global Fund Manager Survey. The survey data revealed that fund managers are taking on more risk, even though they perceive markets as expensive. But how irrational is that really?
It was December 5th 1996 when former Fed Chair Alan Greenspan held his memorable irrational exuberance speech. The NASDAQ had risen a whopping 80% in the two years prior to his televised talk, as investors increasingly fell under the spell of this new, and promising technology, called the internet. With hindsight, we know it was for a good reason, but at the time Greenspan got spooked by hefty market valuations.
If only Greenspan had known that the NASDAQ would go on to rise another 300% in the three years thereafter? An excellent case of ‘The market can stay irrational longer than you can remain solvent’. However, it would not be fair to investors to end my blog with this Keynesian cliché. This because, in fact, a lot of things are looking pretty decent for equities right now.
Take GDP growth, for example, which looks outright positive. Germany’s economy grew by 2.8% year-on-year. Until very recently, most economists thought this number to be impossible for such an aging European country. US economic growth hit 3% (annualized) for the second quarter in a row in and Japan’s GDP grew for a seventh consecutive quarter, something we have experienced in almost two decades. Even Italy managed to squeeze out a growth number just shy of 2%.
Equally important is the fact that this acceleration of GDP growth is translated into earnings growth. The graph below shows that earnings per share have risen sharply since the second half of 2016. Before that, earnings growth looked wobbly at best. But during the last quarter, earnings per share have finally reached new highs.
It’s all relative
More growth and more earnings. Not a bad starting point for adding some equity risk, right? However, as mentioned above, it was mostly valuation that caused Greenspan headaches. Please take a look at the chart below, which shows the realized P/E ratio of the MSCI World Index over time. As can be seen, equities valuations were very stretched in the late 90s, and also quite a bit higher compared to current levels. Just to make clear, I think equities are far from cheap, currently. Especially US equity valuations look rich, whereas valuation in Europe and emerging countries is less demanding. One additional remark concerning this graph: there are two periods, 2002 and 2009, in which the valuation of the MSCI World Index was even higher than in the late 90s. In times of recession, like in 2002 and 2009, company earnings plunge, pushing the P/E ratio up. However, this was definitely not the case during the dot com bubble.
Looking at just equity valuations is a bit too simplistic. Within investing, it’s all relative. It’s a never-ending search for the most attractive asset class. In the chart below I have plotted the earnings yield of US equities against the average yield on US Treasuries. The earnings yield is just the inverse of the P/E ratio. The higher it is, the more attractive equities become. The chart reveals that, while US equities are certainly expensive, US Treasuries are even more expensive. In the late 90s the US Treasury yield topped the earnings yield, but has since fallen far below it.
And, if we move to the other side of the Atlantic, things look even more extreme. The ongoing stimulus by the European Central Bank are reflected in Eurozone government bonds yields, which are still barely above zero. The earnings yield of Eurozone stocks lies way above that, even though Eurozone stocks not that cheap. When given the choice between bonds or equities, my guess is many investors opt for the latter.
Obviously, comparing the relative attractiveness of equities does not stop at government bonds. In recent days, many investors and media items have pointed to falling high yield bond prices and the negative impact this must have on equity prices. First, historical data reveal this relationship is hard to substantiate, and this specific episode is no exception. Relative valuation looks like an explanatory factor here as well. The chart below again plots the US earnings yield, but this time against the average yield on US high yield bonds. Admittedly, the blue line, representing the yield on high yield bonds, lies above the black line, representing the earnings yield, as of today, but the gap is pretty different from where it was during the dot-com bubble.
In the Eurozone, the average yield on high yield lies significantly below the earnings yield. Unfortunately, my Bloomberg data series does not go back all the way to the 90s, but taking into account the charts presented above I think it’s fair to say that Eurozone high yield is expensive relative to Eurozone stocks. It seems equally fair to assume that the least attractively valued of the two assets will be hit hardest when market sentiment turns. Hence, I can imagine investors going for equities, at least in the short-term, here as well.
Given the solid pace of economic growth, the steady rise of company earnings, and the valuation of equities relative to other asset classes, investors seem far more rational than back in the late 90s. That increasing your equity weight implies higher risk, is no surprise. After all equities remain the most volatile asset class, even though volatility has completely collapsed this year. By the way, this raises the question if fund managers have actually increased total portfolio risk. Anyway, I suspect Alan Greenspan has less sleepless nights now than roughly two decades ago.