US stocks are overvalued – but they could get a lot more expensive

The word ‘bubble’ gets tossed about a lot by the financial media.

It’s become quite an emotionally-loaded term. People often use it to dismiss an asset class they disapprove of (‘bitcoin is a bubble’), or a bull market they’re not involved in.

It’s also an over-used way to draw attention in headlines, as in ‘Is this dotcom bubble 2.0?’

If it’s to be useful to us as investors, we need something a bit more scientific to let us know whether or not a market is overvalued enough to qualify as a bubble.

Thankfully, US wealth managers GMO are experts in bubbles – and they’ve got the perfect definition.

What is a bubble?

Jeremy Grantham’s team at GMO defines a bubble as an event that is “two standard deviations from the mean”.

In non-statistical talk, that’s when a market gets unusually overvalued compared to the average. It’s the kind of thing you’d expect to happen very rarely – once every 44 years, to be precise.

The important thing about bubbles, of course, is that they burst (if they didn’t, they’d be safe to invest in).

And what GMO found was that in all the major bubbles they identified – markets that had hit this two standard deviations level – the bubble went on to pop. The markets in question “eventually retreated all the way back to the original trend that had existed prior to each bubble”.

Examples include US stocks in 1929, Japanese commercial property in 1991, US housing in 2005/06, and of course, the global bubble of 2008.

The question today of course is: are we at bubble levels again?

Grantham is well-known for being fairly bearish on the market. But he did call the bottom in March 2009, so he’s not a stopped clock or a ‘perma-bear’ by any means.

While US stocks look overvalued on the cyclically-adjusted price/earnings ratio (CAPE), they are still only 1.4 standard deviations from the mean. In other words, they’re expensive – but they’re not at tech bubble levels yet. To get to ‘bubble’ levels, Grantham reckons the S&P 500 would have to hit around 2,250.

How the S&P 500 could hit 2,250

So will it get there? You might think that with the Federal Reserve ‘tapering’ off quantitative easing, it’s hard to see that happening.

But the other issue is that we’re not far off entering the third year of the US electoral cycle. Barack Obama was re-elected in November 2012, so we’re near the halfway point for his latest term. And that’s when the campaigning will start in earnest.

Why does the third year matter? It’s all about politics. No serving president wants the economy to go pear-shaped in the run-up to the election. So the Fed becomes particularly willing to bail the market out if things look like turning nasty.

This might sound like a load of market-timing voodoo, and I have to admit I tend to be sceptical of these things. But the evidence since 1964 is quite striking. Since then, on average, the S&P 500 returned 2% in the first year of the cycle, and lost 5.7% in the second year.

In the fourth year, the average gain was 5.6%. For the third year – a whopping 20.9%. During the third year, it also pays off to be in the riskiest stocks, which returned 26.2% on average. They typically lost money in every other year of the cycle.

In other words, if you’re going to take a punt, do it in the third year of a presidential cycle, because that’s when the Fed is most willing to catch you if you fall.

You don’t need to invest in the US to profit from American gains

So what does this all mean for you?

Grantham reckons that, although the market is overvalued, it is likely to have a strong run from around October this year, up until the next election. By that point it “will have rallied past 2,250, perhaps by a decent margin”.

Then the bubble will burst, taking the market back down to “around half of its peak or worse, depending on what new ammunition the Fed can dig up”.

That’s an unpleasant prospect for a value investor. I don’t really like the idea of buying an expensive market on the basis that it’s likely to get more expensive. For a start, it relies on our best guesses at the behaviour of crowds being accurate. For another, if you want to make money from it, you also have to sell at the right time.

The good news is that, even if you’re tempted to time the market, you don’t have to invest in the US to benefit from the US presidential cycle. With the US being the most important stock market in the world, the rest of the developed markets tend to do well too during the third year of the cycle. Britain, Europe and Japan all tend to do better than average as well, and they’re all cheaper than the US market.

And of course, if you want a really cheap, despised market, you could buy Russia – as my colleague Merryn Somerset Webb notes.

Also, for more great investment ideas, if you missed the MoneyWeek conference on Friday, you can get a hold of all the speeches and notes here. Many of the attendees told me it was our best conference yet and I have to say I’d agree with them.

High points included Jim Mellon, with a fascinating and inspiring talk on the incredible advances being made in medical technology; and Terry Smith, with his brutal but spot-on critiques of the fund management industry.

It’s really worth listening to the lot – find out how to get hold of them here.

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  • Chester

    I’m not so sure it matters where we are in the electoral cycle. What will drive markets either way is social mood. All time equity market highs have been made whilst mood was elevated, as reflected in record leverage. Sentiment is also at an extreme. the point at which significant trend reversals usually happen. And usually, they happen when the mood music and the mainstream press, which reflects it, are busy looking the other way

    If the reversal happens, the best defence is likely to be US$ cash / ultra short T-Bills. Other asset classes could present significantly more risk, which is again a view not shared by many. US$ / Euro parity is the first likely target, which could be followed by US$ / £ parity when things get really serious. Time will tell soon enough, but as all financial panics have taught us, cash is the only asset to hold when everything else shuts down. Ask the Cypriots who tried buying anything with gold or credit – didn’t happen

  • IJ1

    Bears essentially capitulating and calling for a massive bull run extension leads me to think we may be nearing a top. Remember Hugh Hendry’s unfortunate and somewhat desperate year-end note in which he said the bull market was only getting started and we should all buy 3d printers, traditional valuation measures be damned…? THose are down 50% this year. To be fair to Grantham, he acknowledges we may be in for a setback in the short term. As for the 2250 by Nov 16 call, It’s hard to argue with his reasoning, which is that Yellen is no less likely, and maybe even more likely, than her predecessors to throw tonnes of money and unconventional policy at the slightest whiff of trouble and, in so doing, blow bubbles. I’m just not sure whether this Greenspan era can be sustained for that long, particularly with even more debt in the system than before. Surely there comes a point where faith in central bankers just evaporates. Otherwise why don’t we just keep borrowing and speculating in stocks forever?

  • AndyE

    John, could you define what you mean by the “mean” in this context please? Is it a long-term moving average? If so, it would be possible to identify bubble levels in stock market charts using Bollinger Bands.

  • JGH

    Isn’t there something a bit illogical about predicting rising markets by saying that this is what typically happens in the third year of the US President’s term, and then forecasting a 50% fall the following year in contradiction of the long term averages showing a modest rise for that year ?