There is no bubble in stocks – the real threat lies elsewhere

As the world’s stock markets shoot up to near all-time highs, there is plenty of talk of a bubble in equities. But it’s not stocks that should worry investors, says John Stepek. Here, he explains where the real bubble is forming.

By John Stepek

published 22 May 2013

in Features

After you've been damaged by one bubble bursting, it's easy to start seeing bubbles everywhere.

With stock markets shooting up around the world to above or near all-time highs, there's plenty of bubble-spotting going on in the press right now.

And it's entirely fair to say that without central banks printing lots of money, markets wouldn't be where they are right now.

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But are stock markets in bubble territory? I don't think so. In fact, stocks could be one of the best places to have your money right now

Stock markets are vulnerable but they're not at bubble levels

Stock markets are being propped up by quantitative easing (QE) and loose monetary policies around the world. That almost goes without saying. The latest surge in markets which had been looking a little tired in March - has been driven very much by Japan's monetary easing.

And if the Federal Reserve decided to end QE tomorrow, markets would not like it. I don't see the Fed ending QE tomorrow, and I suspect Ben Bernanke will confirm that view tonight when he talks to US politicians.

The point is, I don't think there's any argument with the notion that QE has helped to send stock markets higher.

But that doesn't necessarily mean that stock markets are in a bubble. As Josh Brown of The Reformed Broker blog points out, this isn't 1999. Even the US a market which I consider to be one of the least attractive around just now is much cheaper than it was back then.

In 1999, the S&P 500 was trading on 33 times earnings. Now, it's on 14. And while it is expensive in terms of the cyclically-adjusted p/e ratio (Cape), at around 24 which is one reason why I prefer other markets back then, the Cape hit 45.

Yes, there are lots of reasons to be wary. Profit margins are unusually high, the economic backdrop is weak, banks remain fragile, and central banks are messing about even more than they normally do. But these are not bubble valuations. We talk about markets hitting all-time highs, but what other assets do you know of that are still trading at lower prices than they were 14 years ago?

Better yet, some markets are genuinely cheap. These are the ones that we've been suggesting buying for a long time now Japan, Italy, maybe some other eurozone peripheral stocks if you feel really adventurous (my colleague Matthew Partridge had the nerve to invest in Greece, for example, which has turned out rather well, though it's not one I'd feel comfortable taking more than a punt on).

QE is a worry. But it's also very hard to predict when the taps will be turned off. Basing your investment strategy around picking that turning point, and sitting in cash until it comes around, is going to prove expensive.

And while stocks are overdue a correction, you could have said that any time in the past three months now. It's equally likely that nothing significant enough happens to push them lower, and that everyone who's worried about missing out piles in and sends stocks a lot higher.

The real bubble is in bonds

If you're looking for bubbles, bonds are the place to look. Taken as a group, yields are close to or at record lows (and therefore prices are at record highs). And unlike stocks, this isn't coming back from a brutal bear market. This is coming at the tail-end of a 30-year bull market. That sounds a lot more like a bubble to me.

And in case you're thinking: "but how can it be a bubble if lots of people are talking about it?", then I'd ignore that. People know when an asset class is in a bubble. Jeremy Grantham of GMO tells a great story about sending a survey to other fund managers at the peak of the tech bubble. To cut a long story short, they virtually all acknowledged that stocks were heading for a big fall they just weren't happy to tell their clients that. Perhaps bond fund managers are just a little more honest.

So if you're looking for signs of stress, the bond market is the one to watch. And keep an eye on one area in particular emerging markets. As the guest speaker at our MoneyWeek Conference last Friday, the excellent Russell Napier pointed out, the government of Rwanda has been able to borrow money at just under 7% for ten years. If that's not a sign of irrational exuberance, I'm not sure what is.

Russell reckons that the next crisis will kick off in emerging market debt. We'll be writing more about this in the near future it's going to be a big theme.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.