Investing in undervalued securities worldwide

Markets are Expensive but Not in a Bubble

Share Article:
Summary
  • The U.S. stock market looks expensive, judging by the Shiller CAPE ratio.
  • But CAPE should not be used to time the market.
  • Persistently low (real) interest rates imply that the market can stay expensive for a long time.
  • For those willing to deviate from the index, value stocks offer higher expected returns than the market in general.

“Today in the U.S. we are in the fourth superbubble of the last hundred years,” Jeremy Grantham, co-founder of asset management group GMO, asserted in an article “Let the Wild Rumpus Begin” published a few weeks ago. The article received considerable media coverage in part because it was published when there were fears the stock market was entering its first correction in two years. Stocks had steadily risen in 2019, 2020 and 2021, fuelled by fiscal and monetary stimulus, and the bubble argument was thus intuitively plausible.

In his article, Grantham argues that stocks, real estate and commodities are all badly overvalued. “This time last year it looked like we might have a standard bubble […]. But during the year, the bubble advanced to the category of superbubble, one of only three in modern times.”

Grantham relates the U.S. stock market today to those in 1929 and 2000. Both were bubble years which were followed by famous market crashes. In the housing market, Grantham equates the current situation with Japan in 1989 and the U.S. in 2006. Both housing bubbles ended badly.

Markets are expensive relative to history

Grantham’s bubble argument is based on the fact that stock and housing market valuation levels are significantly above their long-term trends.

The valuation level of the stock market can be assessed with the cyclically-adjusted price-earnings ratio (CAPE) developed by Yale professor Robert Shiller. The higher the CAPE, the more expensive the market.

The long-term average CAPE is 17, but at present, CAPE is much higher, 36. This could be interpreted as meaning that the market would have to crash by 50% in order for the overvaluation to be eliminated.

Shiller CAPE, 1871-Present (Robert Shiller, multpl.com)
Markets are difficult to time

While many, like Grantham, believe that sooner or later market valuations will revert to mean, there is no natural law that says this must happen.

A few years ago, Dennis Tilley of Merriman Asset Management published an article about the problems that can result from using CAPE to time the market.

The first problem is that CAPE is popular because it has worked historically. But that might just be luck. Tilley gives examples of other indicators that were once widely used but lost their popularity over time as they ceased to function.

The second of Tilley’s arguments against CAPE is that investors were historically unable to improve risk-adjusted returns by using it. When the stock market CAPE was low, risks were high, and non-equity investments were also cheap. As an example of this, Tilley cites the early 1980s, when the stock market CAPE was low, but there were also good returns available in the fixed income markets.

Tilley’s third and perhaps most important argument is that there is no inherent reason why CAPE should revert to its mean over a period of time that is of interest to investors. It can take, for example, 25 or 50 years for mean reversion to happen. An investor who stays out of the stock market for that long will almost certainly lose out to a buy-and-hold investor.

Low interest rates = expensive stocks

Tilley’s last argument explains why CAPE has long been above average.

Interest rates have fallen steadily in recent decades. There is a number of reasons for this, including a slowdown in economic growth, demographic change, China’s integration into the world economy and growing inequality. The direction of these trends is unlikely change in the near future, even if it has been argued that demographic change may eventually start to pull interest rates higher.

Real interest rates in advanced economies (Rachel L. & Smith T. (2015). Secular drivers of the global real interest rate)

If interest rates are low, stocks can and should be expensive, because they are priced in relation to what is available in other markets. Shiller himself has recognized this and now publishes a measure called the Excess CAPE Yield.

Robert Shiller

When assessing market valuations, it is also important to note that in recent decades, the rise of index funds and reductions in brokerage commissions have made investing in stocks cheaper, and awareness of the good historical returns of the stock market has spread.

All of these factors contribute to the outcome that the “fair” CAPE of the U.S. stock market is currently significantly higher than the historical average 17.

CAPE, Tilley concludes, is a better tool for estimating return expectations than for market timing. Currently, the U.S. CAPE 36 implies that return expectations are low compared to history. That does not mean that shares should be sold, however, as they may remain more expensive than average for a long time, and they are still priced to produce positive excess returns, judging by the Excess CAPE Yield.

Value stocks attractively priced

For those investors who want to pursue higher returns than the U.S. market seems to offer, based on its CAPE, there are sectors in the market whose valuations have not risen in the same way as in the U.S. Value stocks have done badly for a long time, so their valuation levels relative to growth stocks have become exceptionally attractive in recent years.

The gap between growth and value stock valuations is currently the widest ever, even wider than at the peak of the technology bubble in early 2000, asset manager AQR asserted in December 2021. This is interesting because after the bursting of the 2000 bubble, value stocks beat growth stocks every year until 2007.

Global Value Spreads (AQR)

More generally, when the history of the market has been studied, it has been found that the cheaper value stocks are relative to growth stocks, the better their future returns have been. In the current situation where the spread in valuations is significant, value investment firm Research Affiliates predicts that value stocks will beat their benchmarks by about 5 percent a year. Similar predictions can be read from other sources.

Now may be the best opportunity in two decades to invest in value stocks, argued asset manager GMO’s Ben Inker last year. I believe this is true. The stock market is generally expensive, but this does not mean that investors should stop investing in equities. The market is not in the bubble described by Grantham, and value stocks are still reasonably priced. The growth-value spread suggests that by investing in value stocks, investors will be able to achieve significant excess returns in the 2020s.

Share Article:

Leave a Comment

Your email address will not be published.

Disclosures

eToro is a multi-asset platform which offers both investing in stocks and cryptoassets, as well as trading CFD assets.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 67% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work, and whether you can afford to take the high risk of losing your money.

eToro (Europe) Ltd., a Financial Services Company authorised and regulated by the Cyprus Securities Exchange Commission (CySEC) under the license # 109/10.

eToro (UK) Ltd. is authorised and regulated by the Financial Conduct Authority (FCA) under the license FRN 583263.

Your capital is at risk. Other fees may apply. For more information, visit etoro.com/trading/fees.

Pietari Laurila is not a registered investment advisor and does not offer investment advisory, fund management or wealth management services.

Triangula Capital is a brand name, not an incorporated entity.

This page is provided for information purposes only. It is not a recommendation to copy the Triangula Capital strategy or to invest in any fund or security.

2009-2020 performance figures are from Pietari’s personal Interactive Brokers account. They are time-weighted returns calculated in accordance with the Global Investment Performance Standards (GIPS).

From 2021, performance is calculated by eToro.

Past performance is not indicative of future results.

Track Record

It is often said that past performance is not a guarantee of future performance.

That is true. But there is also some evidence indicating that portfolios that performed better in the past, do perform better in the future.

“[…] top-decile prior-alpha funds produce annual future alphas of about 150 bps, net of fees” Source

Risk warning: That is only one study. In general, past performance is not indicative of future results.

Aligned Incentives

Pietari invests the majority of his net worth in the strategy. This ensures that his interests are aligned with investors who copy the strategy.

“Funds with high-incentive contracts deliver higher risk-adjusted return, and the superior performance remains persistent. The top incentive quintile of funds outperforms the bottom quintile by 2.70% per year” Source

Risk warning: Pietari holds accounts with multiple brokers and may therefore have a conflict of interest when deciding which accounts he should trade in first.

Unconstrained Investments

The strategy has fewer constraints on its investments than traditional mutual funds.

The strategy portfolio can be invested in stocks, bonds or cash and these allocations can vary over time.

Compared to traditional mutual funds, the strategy also:

  • holds fewer securities
  • trades more
  • avoids following the index

Each of these points has been shown to be an important predictor of portfolio performance.

“We […] find that portfolio concentration is directly related to risk-adjusted returns for institutional investors worldwide” Source

“A one-standard-deviation increase in turnover is associated with a 0.65% per year increase in performance for the typical fund” Source

“We find that truly active funds significantly outperform closet indexers. Further, we find that the truly active funds are able to outperform their benchmarks on average by 1.04% per year” Source

Risk warning: Concentrated portfolios with few positions can suffer large losses if bad news arrives about any of the companies in the portfolio.

Higher Risks for Higher Returns

The aim of the strategy is to maximize returns, even if this means taking more risks than usual.

The strategy invests in countries and sectors where values have collapsed due to macroeconomic problems.

Within these geographies and sectors, the strategy overweights stocks that trade at low valuations on measures such as price-to-earnings or price-to-net asset value.

Every stock in the strategy portfolio must also be a good company, with no obvious red flags or long-term threats to its business model.

Risk warning: The strategy portfolio tends to be concentrated in risky stocks, which means that its losses in any market downturn will likely exceed those of the market index.