A few years back I read a book called The Great Depression - A Diary which was written by a lawyer during a multi-year period in the 1920s and 30s. What was really interesting about this book was that it was all written in real time so the writer was making assessments about the current environment and future outcomes without having his opinion clouded by hindsight. Often when people write accounts of historical events, after they already know the what happened, it tends to cloud their judgement and make everything seem more predictable than it actually was. Nassim Taleb writes extensively about this in Fooled By Randomness and The Black Swan.
We are currently experiencing what appears to be a unique period in the financial markets. I wasn't old enough to properly experience the tech boom of the late 90's but there is certainly some excessive behaviour going on today. Many people are pointing to central bank money printing as the culprit but I'm not sure they are solely to blame.
I suppose the question everybody is always asking is 'Are we in a bubble'. In my opinion the word bubble is thrown out too often these days, mostly by bears who missed out on the ride up. It's very rare that I hear people who have had great returns over the past decade proclaim bubble. It seems to be mainly perma-bears like John Hussman or Jim Chanos continuing to claim we are at peak stupidity in the market.
The term bubble is used these days to describe anything that is a bit overvalued, whereas historically it was used to describe a period of excessive optimism combined with assets trading at irrational prices.
If we compare today's stock prices with historical periods I would agree that things certainly look a bit pricey. Every fundamental 'value investor' metric like Price to Sales, Price to Earnings, and so forth are in the 95th percentile. On the surface this looks like an obvious bubble. If valuation metrics are at the highest levels ever, higher than even the tech bubble, then this must be an even greater bubble right?
The one key difference is interest rates. Interest rates and more specifically the risk free rate are at the lowest they have ever been. The risk free rate is the yardstick against which all other non risk free returns are based on. For example if an investor can get 6% return by buying a risk free bond, then they would be less likely to buy a stock returning 4%. They may still go ahead with the stock purchase if they believed that future growth would result in a higher yield in the future, but most rational investors would simply go for the bond.
When interest rates are near 0% (like today) an investor would be more likely to accept a stock that yields 2% or 3%. Or they may choose to sit on their cash in the hope that in the future there will again be opportunities to buy stocks returning 6% or greater. This is never an exact science, so the investor should always be weighting up the different options. For example, today if an investor wanted to put money to work for ten years they have the following options.
We are currently experiencing what appears to be a unique period in the financial markets. I wasn't old enough to properly experience the tech boom of the late 90's but there is certainly some excessive behaviour going on today. Many people are pointing to central bank money printing as the culprit but I'm not sure they are solely to blame.
I suppose the question everybody is always asking is 'Are we in a bubble'. In my opinion the word bubble is thrown out too often these days, mostly by bears who missed out on the ride up. It's very rare that I hear people who have had great returns over the past decade proclaim bubble. It seems to be mainly perma-bears like John Hussman or Jim Chanos continuing to claim we are at peak stupidity in the market.
The term bubble is used these days to describe anything that is a bit overvalued, whereas historically it was used to describe a period of excessive optimism combined with assets trading at irrational prices.
If we compare today's stock prices with historical periods I would agree that things certainly look a bit pricey. Every fundamental 'value investor' metric like Price to Sales, Price to Earnings, and so forth are in the 95th percentile. On the surface this looks like an obvious bubble. If valuation metrics are at the highest levels ever, higher than even the tech bubble, then this must be an even greater bubble right?
The one key difference is interest rates. Interest rates and more specifically the risk free rate are at the lowest they have ever been. The risk free rate is the yardstick against which all other non risk free returns are based on. For example if an investor can get 6% return by buying a risk free bond, then they would be less likely to buy a stock returning 4%. They may still go ahead with the stock purchase if they believed that future growth would result in a higher yield in the future, but most rational investors would simply go for the bond.
When interest rates are near 0% (like today) an investor would be more likely to accept a stock that yields 2% or 3%. Or they may choose to sit on their cash in the hope that in the future there will again be opportunities to buy stocks returning 6% or greater. This is never an exact science, so the investor should always be weighting up the different options. For example, today if an investor wanted to put money to work for ten years they have the following options.
- 10-Year Treasury - 1.57% Yield, this is fixed yield for the full ten years.
- S&P 500 - 2.35% Yield, this yield should grow over time as companies increase earnings, but this is not guaranteed
- Cash (Fed Funds Rate) - 0% Yield, this yield will stay at zero but you are preserving optionality to buy bonds or stocks in the future at a higher yield than right now.
If we compare the three options above with January 2000, close to the peak of the tech boom we get the following
- 10-Year Treasury - 6.68% Yield
- S&P 500 - 3.45% Yield
- Cash (Fed Funds Rate) - 5.7% Yield
Notice that at the peak of the tech boom an investor had the option to leave their money in cash (in a savings account) and receive a risk free return of almost 6%. Or they could put their money in stocks and only get 3.45%. This highlights how crazy the mentality was at that time and why now isn't quite the same. I will start to get worried about today's market a lot more if the S&P earnings yield goes below the 10-Year Treasury rate. For now though I will just continue to monitor things.