A look at whether there really is an equity bubble yet
It is a commonplace today that equities are expensive by most historic standards. Whether the criterion be price to earnings, longer term Schiller ratios or the recently popular market cap to GDP measures, Developed Market equities are either at, or close to, all-time highs. The only precedent was the end of the 1990s and the eventual dotcom bubble.
The explanation usually given to justify valuations, and one I would happily subscribe to, is the nine years of easy money which we have enjoyed since the last financial crisis. Because industry has found it hard to find profitable ways to employ this money in the real economy, much of it has flowed over into investment assets including financial ones. Prices of bonds, equities and property have all gone up.
We have lacked, however, a way of quantifying how far prices have gone up relative to the level of liquidity – ie. how far the bubble has inflated. A recent article from CrossBorder Capital aims to do precisely that by looking at stock market capitalisation relative to the pool of available financial assets. It is effectively a measure of the size of the equity weighting within investors’ entire financial asset portfolio. In theory, much as with any portfolio, if the ratio becomes too high investors should react to reduce it.
CrossBorder’s conclusions are that generally, on this market cap to liquidity basis, global equity valuations are at around the middle of the range pertaining since 2000 and well below the dotcom bubble peak. Even the US looks no more than a tad expensive while Emerging Markets, and to an extent Japan, look cheap.
This is not an argument for complacency. There is clearly scope for a sharp fall in equity prices if the authorities choose to take liquidity, the ultimate denominator of this measure, out of the market by tighter monetary policy. But it does suggest that we are not really in a bubble yet and that if - admittedly a big ‘if’, given the noises coming out of the Federal Reserve - the level of cheap money is broadly sustained, valuation levels alone will not prevent equities from rising further.
CrossBorder's full article is available to purchase here.