Surging US equities stir heated debate over possible bubble

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US stock indices are at record highs but the exuberance is not irrational, say bullish analysts, because the level of valuations is justified by strong earnings and a market with some of the world’s most profitable companies.

Predictions of a bubble in US equities have been growing more insistent during the past two months as sharp rises in stock prices have pushed the big three boards up into uncharted territory.

So far this year, the Dow is up 24% after peaking above 16,000, the broader S&P 500 is up 28% after breaching 1,800, and the Nasdaq is up 35% and extending its break above 4,000.

The bubble fears are reasonable: The last time the Nasdaq was at these levels was in 2000 at the height of the dotcom bubble, prompting economists such as this year’s Nobel Prize winner for economics Robert Shiller to join the chorus of warnings of a bubble, particularly in technology and financials.

The more bearish are equally adamant the moving-day and moving-week average technicals dictating current valuations are overdue a pullback.

The cyclically adjusted price/earnings ratio is around 25 times compared with the long-term average of 16.5, which, according to this measure, means US equities are overvalued relative to long-term trend, and would take a 35% correction to bring to fair value.

Glaring examples include Twitter, which despite posting a Q3 loss of $64 million on revenues of $168 million is up 55% on its IPO price, valuing the company at $26 billion.

However, further signs of economic recovery could alleviate some of the worry by compensating for the potential fallout from the US scaling back quantitative easing (QE) – likely now in January. Many believe much of the cheap cash from the Fed’s money-printing stimulus programme has found its way into the stock market.

Unemployment fell unexpectedly to 7%, its lowest level in five years, as firms’ payrolls swelled by 203,000 in November and the economy grew at an annualized rate of 3.6% in the third quarter, substantially above the 2.8% the US Commerce Department initially estimated.

“I’m very comfortable with the level of valuations,” says Guy Foster, head of portfolio strategy at Brewin Dolphin. “It was a decent a year for earnings and you’ve got some of the most profitable companies in the world in that market.

“The naysayers would point to the cyclically adjusted price-earnings ratio, but we’ve analysed that in quite some detail and we find there’s very little comparability about the various measures of earnings that have been used over time.”

He adds: “Whilst the best returns may have been had, I certainly wouldn’t see anything approximating a bubble in US stocks. There are definitely some stocks where you would question the valuation, but there are plenty more which look extremely sound.”

Foster says tech and social media plays, such as Twitter, that have sky-high valuations based on very bold projections of increasing revenues, are the exceptions rather than the rule.

“Take something like Google, by contrast,” he says. “It’s probably the most profitable company in the world and could probably be significantly more profitable if it so wished just by reducing its R&D spending.

“I don’t believe QE is driving the market because a lot of money is flowing out of the US and a lot of money is remaining on banks’ balance sheets.”

He adds: “You compare, say, an equity valuation to a bond valuation and you conclude that the equity looks much better value. You compare the bond valuation to what you can get on cash and you conclude that, actually, even the bonds don’t look terribly expensive. It all just underlines the fact that equities are quite good value.”

Tech stocks that have seen massive price run-ups this year include 3D Systems, LinkedIn, Facebook, Priceline.com, Amazon and Google. All except Priceline and Google have P/E ratios of 80 or more. LinkedIn and Amazon’s estimated P/E’s for this year both top a staggering 500.

Financials that have seen similar price run-ups, albeit with less stratospheric P/E’s, include Altisource Portfolio Solutions, Virtus Investment Partners, Ocwen Financial and HCI Group.

Appetite for new stocks has been growing strongly, with IPOs on track for by far their busiest year since the financial crisis, up by more than two-thirds on the January-to-December period in 2012.

Technology and financial companies accounted for more than 40% of the 210 flotations in the year-to-date and 35% of the $49 billion raised, according to data from Renaissance Capital.

“There is a bit of a bubble and we need a correction,” says Michael Hewson, chief market analyst at CMC Markets. “When you look at the technicals and you look at the distance that the S&P and the Dow are away from the 200-week and 200-day moving average, at some point there needs to be either a sideways consolidation or a correction.

“I’m not saying we can’t see higher values, but the values that we’ve seen so far are overdue a bit of a pullback. It’s all Fed dependent, but as long as the growth story continues the market doesn’t need to fear tapering. The Bank of England stopped its asset-purchase programme over a year ago and the bottom hasn’t fallen out of the stock market here.”

He adds: “Valuations are stretched and they need to come back to reality a little bit. We have seen a slight correction in the S&P to around 1,787 but we can fall back to 1,720 and the uptrend will still be intact. I don’t think we need to fear it.

“The market needs to be pulled off its dose of monetary sugar. It needs to happen and the sooner the better, and then we can get a fairer idea of what a fair valuation is on the stock market. At some point stock markets are going to need to revert back to their long-term mean.”

Hewson concludes: “The 200-day moving average is at 1,650, which is quite a long way away, and we haven’t been as far away from 200-week moving average at 1,350 in quite some time.

“The last time we were at the 200-week moving average was January 2011 so at some point this little bubble in US equity markets needs to pop. And if the Fed tapers, we’ll get it.”