In the course of about a year, we’ve gone from fears of the next great depression, to rumblings of asset class bubbles all around us. So what is an investor to think? Are we in a bubble? To properly answer that, we need to look at where prices are, what’s fueled the rise, and what red flags to look for in asset valuation.
Taking a look at the first part of the question, it’s easy to see why some eyebrows may be raised about the current price level of many assets. The graph below shows the rise of home prices and the S&P 500 Index since early last year.
Considering the average annual growth rates for home prices and stock prices historically are about 4% and 10% respectively, jumps of 24% and 90% are certainly abnormal. The first earmark of a bubble is rapid growth far above historical norms, so from that perspective, the current market fits that bill. However, as with everything, context is everything. These 1-year numbers that seem sky-high are mostly a result of the significant drop in prices that occurred in those early days of Covid. One of the greatest tricks of many financial pundits is to selectively choose endpoints that support whatever narrative they are trying to present. A good way to combat this and get a more realistic view of where these prices stand is to change those end points. When we do that, we see a different picture. Below is a list of several asset classes, but with the beginning date of 3 years ago instead of starting from the bottom of a year ago.
With the exception of the S&P 500 stocks, which I wrote about earlier having some concerning qualities, the rest of the market had 3-year returns actually below their historical norms. Additionally, while the increase in average home prices is slightly above average when looking back 3 years, it’s not approaching the run-up we saw in the early 2000’s.
So given the fact that this data is readily available, why are we so quick to jump on this narrative of a bubble that will inevitably pop and leave behind a destructive wake of depressed asset prices? Because this is exactly what we’ve seen happen twice in the last 20 years, and we are programmed to spot patterns that lead to pain and avoid them. Tech stocks in the early 2000s and home prices a few years later spiked up to indefensibly high levels, leading to significant and sustained crashes following. Naturally since many people suffered great financial losses in these two events, the natural reaction is to see prices in these assets rise to new highs and reflexively think it will follow the same path it did before.
Outside of just looking at recent performance, there are a couple other factors to evaluate to see if the rise in price is justified or if it is entering bubble territory. The first of these is to judge the behavior of investors. “Investors” deploy assets in one of two ways: 1) Traditional fundamental investing and 2) Speculation. Bubbles are earmarked by rank speculation, in which investors are buying an asset not because they believe in the future profitability or usefulness of the underlying asset, but rather because they see it increasing rapidly and are hoping to sell it quickly for more than they bought it. This was rampant in the late 90’s, when tech stocks raged up over several years, despite many of the companies having no fundamentals, no profits, and generally weak prospects. The same thing occurred in the housing market, when developers and even many individuals were using cheap credit to buy up properties they couldn’t afford, hoping to sell them for a quick profit with no intention of ever living in them. This type of speculation is really no different than a pyramid scheme, in which the early adopters get rich on the backs of those that follow them, but the house of cards collapses once there’s no one left to sell to.
It is admittedly difficult to identify a bubble while it’s happening, but one can look at the current marketplace and see that by and large it doesn’t exhibit the telltale signs that were evident during other instances. Stocks are going up in value, but outside of some outliers, their prices as multiples of their earnings are not nearly as high as we saw back in the late 90’s. Conversely, we are seeing housing prices increase, but this time it is not a facet of loose credit from banks leading to the purchase of investment properties. So this begs this question, if it’s not a speculative bubble, what is leading to this increase?
The answer to this question is two-fold, and it is really foundational to what drives market growth in general.
The first factor is expendable money. If people find themselves with more money, they’re either going to spend it or save it. This leads to spending on goods and services, which increases corporate profits and drives up stock prices. People with extra money also tend to buy new homes, which has the obvious effect of increasing demand and driving up home prices.
For many who want to save this extra money, this means investing in the stock market. Once again, this increases demand and leads to higher stock prices. It’s pretty evident that if more money is available to people, it is going to lead to increased asset prices. So why is this relevant? Well it just so happens that the government injected more money into the economy in 2020 than at any point in history.
The chart above shows the overall money supply skyrocketing over the last year. Unlike some past government infusions that went largely into bank reserves, much of this spending went directly into hands of consumers; far more than was lost during Covid shutdowns. Based on these data, one should absolutely expect that stock prices and home prices would have increased over the last several months, which is exactly what occurred.
The second factor that leads to asset growth is very similar to the first. One way to increase spending and thus asset prices is to flood the market with lots of money. Check. The other way is to just make money really cheap. This is done be driving interest rates down. Below is a graph of the yield of a 10-year bond as well as average mortgage rate on a 30-year note.
This may not look like a drastic drop, but from late 2018 thru the end of 2020, we saw the average mortgage rate fall from almost 5% to under 3%, and the yield on a 10-year bond drop from 3% to 1%.
So why do lower interest rates lead to a rise in the stock market? The biggest reason is that if it is cheaper to borrow money, it is easier for companies to make a profit. For example, say a company could borrow $1 Million to invest in a new product line with the assumption that it will generate a 3% annual return, if the cost to service their debt is 3%, this would not be a profitably investment. However, if the cost of borrowing drops from 3% to 1%, all of a sudden an investment that wouldn’t have previously been profitable turns into one that is profitable with this new, cheap money.
A secondary reason goes to the choices of investors. If one has to choose between investing in risky assets (stocks) with a higher rate of return vs. risk-free assets (bonds/CDs), the extra return required by those willing to bear the risk and invest in stocks will tend to fall into an equilibrium, known as the market-risk premium. However, if the risk-free rate of investing drops from 3% to 1%, this equilibrium shifts as well, and investing in stocks all of sudden becomes more attractive not by anything they’ve done, but just simply because the alternative has gotten worse.
The impact on housing prices should be even more obvious. When most people purchase a home, the price of the house itself is much less important than the affordability of the monthly payment. Consider the cost of a 30-year mortgage on a $500,000 home. A couple years ago when rates were at 5%, the P&I monthly payment would have been ~$2700. At a 3% interest rate, that same $2700/mo will get you a $640,000 home. With no additional payment each month, the price of a home someone on this budget could afford increased by 28% as a result of the lower rate. Of course home values are going to increase under these conditions.
While it’s hard not to give pause when we see asset prices skyrocket, especially after a year of lockdowns and stunted economic growth, it’s important to look beyond the headlines and move past initial fears. Once we do, it becomes clear that the fears of a speculative bubble are not warranted, and that asset prices are justified in their recent growth.
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