What are asset bubbles?
In his interview on the Bloomberg channel on July 31, 2017, former Fed chair Alan Greenspan rang alarm bells about the bond market (BND) being in a bubble. He also said that investors don’t need to be worried about equity (SPY) valuations at this time. Let’s take a look at the concept of bubbles.
Asset bubbles are created when investor optimism is driven to excessive levels. In the stock market, bubbles are created when investors estimate high levels of future cash flows for a stock. Stock prices are a discounted value of future cash flows at any given point in time, with future interest rates being used as a discounting factor. Stock prices can always continue to scale new peaks since there’s no limit to investors’ expectations. This phenomenon is popularly known as irrational exuberance. That’s one reason why it’s very difficult to identify a market top or bottom or when these bubbles might burst.
What does market cap to GDP ratio tell about valuations?
In the graph above, you can see the market cap to GDP ratio, which is a useful tool to understand market valuation. For US markets (VTI), the current market cap to GDP ratio is 133.8%. That’s close to the all-time high of 149.0% before the financial crisis of 2008. The current cycle has been accompanied by strong earnings performances by corporations and fueled by abundant liquidity and low interest rates.
Greenspan justifies equity market valuations
It’s difficult to understand why there would be a bubble in the bond markets but not in the equity markets (QQQ). In our view, both markets would be impacted by rising interest rates. Corporations have enjoyed the luxury of ultra-low interest rates in the last decade, but if interest rates rise too quickly, their profit margins would likely take a hit, and we might see a lot of pressure on corporations with low credit quality (HYG).
It’s not likely that interest rates will bounce back abruptly with inflation (TIP) remaining stubbornly low. Greenspan could be right when he says that equity investors don’t need to be worried. But we have to question his views on the bond bubble. We’ll look at bonds in the next part of this series.