It is a mistake to think of the financial markets as a single entity. To answer the question as to whether the markets are overvalued or in a bubble, we have to examine each market separately. In the end, the only market that really appears to be in a bubble is the fixed income market.
Equities
There is evidence that U.S. equities are at the high end of their value range. This is mainly due to the monetary policies of the Fed and the world’s other major central banks. In the equities market, some of the “momentum” stocks, which were in bubbleland (those that have a stratospheric P/E ratio), began coming back down to earth in April.
There are continuing massive liquidity injections by the Fed (now $45 billion/month). And other major central banks have similar policies. The newly created money has to find a home. Interest rates are at artificially low levels, so well-managed money is not attracted to the fixed income market. And since the EM equity selloff last summer, money managers are simply avoiding those markets.
That leaves the U.S. equity market as the darling because it appears to be the safest, especially because the U.S. economy looks to be gaining strength after a rough winter. This was reinforced by the Fed’s statement on Wednesday, when they continued to reduce the amount of newly created money from $55 to $45 billion/month citing an improving economy (despite 0.1% real gross domestic product growth in the first quarter).
When the “taper” is over (or before, because markets “anticipate”), the U.S. equity market will have to face a new reality where billions of dollars of newly minted money are no longer available to push up equity prices. Corrections are inevitable; it would be a big mistake to think that the withdrawal of the Fed’s massive liquidity program won’t have any impact and that it will be business as usual.
But, let me emphasize that U.S. equities are not in a bubble like we saw in 2000 or 2008 where market multiples were in nosebleed territory. There are a few IPOs and new technology companies that remain speculative, and some of them have already seen a correction. Nevertheless, stock values appear to be at the high end of their traditional range, and we haven’t seen a “normal” market correction for several years.
Furthermore, it is likely that the withdrawal of the Fed’s liquidity program, if history teaches us anything, is a seminal event. So, new money that must be put to work, should be patient money, and the investments should be in solid companies with growing revenues, free cash flows, and rising dividends.
Fixed income
Without a doubt, the fixed-income market is in a bubble. Many, perhaps unsophisticated, are reaching for yield without much consideration for risk. Some must believe that governments will step in to shore up failing institutions, like they did in 2009, or maybe they are not thinking about risk at all since the episodes of ’09 are now ancient history. But, be assured, the risks are there.
On Tuesday, Italy sold $12.4 billion at record low yields (3.22 percent for their 10-year — a spread to U.S. Treasury notes of only 52 basis points). By the way, Italy is rated BBB+ by the Fitch rating service.
Less than two years ago, such notes yielded 7.25 percent, and less than a year ago, they were priced at 6.50 percent. The week before, Portugal came to market after a three-year absence (since they screamed “uncle” and asked for aid) and sold their 10 year at a 3.57% yield.
In these cases, investors may be relying on Europe to step in if there are problems in the future.
More telling, during the past week, Numericable, a small French cable company with a junk rating of Ba3 went to market and sold almost $11 billion of notes at yields ranging from 4.875 percent to 6.25 perecnt. Not so long ago, this would have required double-digit yields at a minimum. This example shows that investors are reaching for yield without any regard to risk, as there is almost a zero probability that the French government would intervene if this company had financial issues.
These examples clearly indicate that the bond market, especially the junk bond market, is in bubble territory.
Treasury yields
Since the turn of the year, the 10-year U.S. Treasury note yields have fallen from 3.0 perecnt to nearly 2.6 percent, giving them an annualized rate of return of more than 10 percent.
Some of this was the result of a slow first quarter (weather-related) and uncertainty over monetary policy with a new Fed chairwoman (Yellen) who appears to be willing to keep interest rates lower for longer than markets previously thought. But, even at 2.60%, that yield is 117 basis points higher than the record low of 2012 (1.43 percent ), and nearly 100 basis points higher than the low yield of 2013 (1.66% percent).
Conclusions
The U.S. economy is getting stronger. The Fed continued its “taper.” Rates will only go down if: a) a recession is approaching; b) deflation is reality; or c) the U.S. is about to enter another war. While all of these are possible, they are all highly improbable. Under these conditions, buying long-term bonds that are unhedged is both speculative and dangerous. Of all the financial markets, the only one I see in a bubble is the bond market.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee.
Contact Robert Barone or the professionals at UVA (Joshua Barone and Andrea Knapp) who are available to discuss client investment needs. Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
