US stocks are ticking all the boxes of a bubble

There are five key characteristics to every bubble, says analyst Richard Bernstein. This market meets them all

Most analysts agree that the US stockmarket is overvalued on almost any measure you care to use. You can find pockets of value everywhere, and other global markets aren’t quite as expensive (notably the UK). But when it comes to the US, there’s little argument that investors are paying up for stocks in a way that we haven’t seen other than at previous pre-crash highs. 

Of course, there are still arguments to be had around how much this matters. You may or may not believe that there are good reasons for the apparent overvaluation. Low interest rates are one pertinent factor, and you can argue that online business models, which are far less capital-intensive than “old economy” companies, make a big difference too. And after years of hearing the same “markets are overvalued” story, you may feel sceptical about how useful valuation is as a measure anyway.

That’s where an interesting recent piece of research from US investment manager Richard Bernstein Advisors comes in. Bernstein is a former Merrill Lynch strategist who was bearish in the run-up to the 2008 crash, but persistently bullish afterwards, notes John Authers on Bloomberg. So “he cannot be dismissed as a perma-bear, and the last time he made a bubble call he was right”. Bernstein argues that there are five essential characteristics to a bubble – but overvaluation is not one of them. Instead, bubbles are when “financial speculation is clearly pervading society” – which he believes is now the case. 

What are the five? Increased liquidity; use of leverage; democratisation of the market; increased new issues (as companies take advantage of investor appetite to raise money cheaply); and increased turnover. Money-printing by central banks has left us awash with liquidity. On leverage (see below), Bernstein notes that private investors in particular are using more and more borrowed money and leveraged instruments such as options. “Democratisation” of finance (which Warren Buffett’s partner Charlie Munger is worried about too) is needed to drag in enough new investors to drive the bubble; the “meme” stocks phenomenon around firms like videogames chain GameStop is proof of that. On new issues – both special purpose acquisition companies (Spacs) and initial public offerings (IPOs) are booming. Enthusiastic trading has boosted share turnover. So all the boxes are ticked.

The good news is that Bernstein doesn’t view the whole market as being at risk. Instead the bubble has centred on specific sectors – tech in particular. As a result, “momentum strategies focused on the market’s bubble leadership seem very risky to us”. But prospects for investors in neglected areas such as the energy sector, value stocks and non-US markets are more appealing.

I wish I knew what leverage was but I'm too embarrassed to ask

Leverage (or “gearing”) refers to the extent to which debt rather than equity is used to fund an investment. The term can be applied to a business – which might issue bonds to help pay for the construction of a new factory or take out a mortgage to allow it to buy an office building – but equally for the use of borrowings by an investment trust or hedge fund to increase returns. 

Leverage is also known as gearing; the latter term is more common in the UK, while the former is preferred in the US. The extent of a company’s leverage can be measured through ratios such as debt/equity. Let’s assume that a company has assets worth £100m and debt totalling £30m. Shareholders’ equity, which is equal to assets minus liabilities, will be £70m. Then its debt/equity ratio is 30 ÷ 70 = 43%. The debt/assets ratio, another common measure of leverage, will be 30 ÷ 100 = 30%. 

The company then buys a rival for £50m and finances the deal using a bank loan. Total assets are now £150m, debt is £80m and equity is unchanged at £70m. However, its debt/equity ratio is now 80 ÷ 70 = 114% and its debt/assets ratio is 80 ÷ 150 = 53%. It is now more highly leveraged. You should also look at interest cover, which is earnings before interest and tax (Ebit) divided by interest payable. So if the firm had Ebit of £5m and paid £2m in interest, it would have interest cover of 5 ÷ 2 = 2.5. 

Leverage for a fund is usually calculated in a similar way to debt/assets. Say an investment trust has £100m in capital contributed by investors, borrows £5m and invests £105m. It will then start with gearing of 5%, which will change in line with the value of the investments.

For individuals in the UK, leverage for investing (rather than buying a house, say) is most easily accessed using spreadbetting. This can amplify your returns but of course it can amplify your losses too, and is thus best avoided if you are at all unsure about how it works.

Recommended

What will happen to the price of gold in 2022?
Gold

What will happen to the price of gold in 2022?

Gold is traditionally the go-to asset during inflation. But with inflation at 30-year highs, it has gone nowhere. Dominic Frisby investigates why, and…
20 Jan 2022
UK inflation is at a 30-year high and it hasn’t peaked yet
Inflation

UK inflation is at a 30-year high and it hasn’t peaked yet

UK inflation has hit 5.4% - its highest in 30 years. And it could be heading higher. John Stepek explains what it means for you and your money.
19 Jan 2022
Index fund
Funds

Index fund

Index funds (also known as passive funds or "trackers") aim to track the performance of a particular index, such as the FTSE 100 or S&P 500.
18 Jan 2022
Model Y: Tesla has nailed it once again
Cars

Model Y: Tesla has nailed it once again

The electric carmaker’s new SUV crossover, the Model Y, sets the benchmark in the sector.
18 Jan 2022

Most Popular

Five unexpected events that could shock the markets in 2022
Stockmarkets

Five unexpected events that could shock the markets in 2022

Forget Covid-19 – it’s the unexpected twists that will rattle markets in 2022, says Matthew Lynn. Here are five possibilities
31 Dec 2021
US inflation is at its highest since 1982. Why aren’t markets panicking?
Inflation

US inflation is at its highest since 1982. Why aren’t markets panicking?

US inflation is at 7% – the last time it was this high interest rates were at 14%. But instead of panicking, markets just shrugged. John Stepek explai…
13 Jan 2022
Tech stocks teeter as US Treasury bond yields rise
Tech stocks

Tech stocks teeter as US Treasury bond yields rise

The realisation that central banks are about to tighten their monetary policies caused a sell-off in the tech-heavy Nasdaq stock index and the biggest…
14 Jan 2022