Just for the sake of perspective, today's stock-market valuations aren't as frothy as they were during the great dot-com bubble of more than a decade ago. At the end of 1999, the Nasdaq 100 Stock Index had a price-to-earnings ratio of 99, according to data compiled by Bloomberg. At the end of March 2000, shortly after the Nasdaq peaked, that ratio was 137. Today, it's about 21. The S&P 500 Index's price-to-earnings ratio, by comparison, is about 17, which is neither cheap nor outrageously expensive by historical standards.
Yet there are pockets of bubblelike behavior in plain sight. A new company, Fantex Inc., last month filed to go public while sporting only one source of future revenue: the earnings potential of Houston Texans running back Arian Foster, who promptly pulled a hamstring muscle. (It has since signed a second athlete.)
The biggest names in the stock market nowadays -- "story stocks" or "momentum stocks," they're sometimes called -- include social-media companies such as LinkedIn Corp. ($27 billion stock-market value, 18 times revenue and 746 times earnings) and Facebook Inc. ($122 billion market cap, 18 times revenue and 120 times earnings). Then there's the electric carmaker Tesla Motors Inc. ($19 billion market cap, 14 times revenue and losing money) and the online-entertainment company Netflix Inc. ($19 billion market cap, 4.5 times revenue and 186 times earnings).
The Fed's role in the markets' surge is no mystery. By maintaining its zero interest rate policy and monthly asset purchases of $85 billion, the central bank has crowded investors out of havens such as Treasury bonds and pushed them into riskier assets such as equities and speculative-grade debt. Even the slightest hint that the Fed might taper its purchases has sent bond and stock prices reeling. When the Fed walks back from those hints, markets have rebounded.
Corporate-debt spreads have narrowed severely. Covenant-light leveraged loans are back in vogue. Housing is soaring again in the same markets where it went bust years ago. In San Francisco, Los Angeles, San Diego and Las Vegas, home prices in August were up more than 20 percent from year-earlier levels. The S&P/Case-Shiller index of prices in 20 big U.S. cities is back to mid-2004 levels. It has been heaven for speculators. The Fed could stop the music at any time with one stroke.
Even the CEOs of Tesla and Netflix have expressed amazement at their stocks' recent surges. In an Oct. 21 letter to shareholders, Netflix's Reed Hastings compared his company's stock performance with the "momentum-investor-fueled euphoria" of 2003, the year after Netflix's IPO. Tesla's Elon Musk last week said his company had "a higher valuation than we have any right to deserve."
There is no simple formula the Fed can use to determine if the markets have become too inflated or its own balance sheet too large. These are ultimately judgment calls. Yet one of the problems with the Fed is that for more than a decade, it has erred on the side of letting bubbles grow largely unchecked or acting as if they don't exist, then reacting to the ensuing damage by blowing new ones. If the Fed can't spot signs of bubbles forming now, that's because it doesn't want to.
David Fuller's view It will not have escaped your attention
that a debate is taking place about whether or not we are seeing at least the
early stages of bubble conditions on Wall Street. Among investors, these calls
are too often highly subjective. For instance, some investment managers who
are long and leveraged, are talking confidently about 'further P/E Ratio expansion
because conditions are so favourable'. I heard this on CNBC while in the home
gym Thursday morning, and the so-called logic of this view helped me to speed
up repetitions on the circuit machine. Conversely, Graham & Dodd or Austrian
School value investors may now be somewhat underweight equities and are issuing
warnings of bubble conditions.
Compare this sentiment with barely over a year ago, when a majority of investors were seriously worrying about another big stock market crash and the S&P500 Index was establishing an important low at 1343. This week and some 432 points higher as of last Wednesday, they are talking about 1800 by Christmas. They may be right because the monetary tailwind remains powerful. However, this stock market is no longer cheap at just below a PER of 17 for the S&P 500, and earnings have been flattered by corporate share buybacks.
Fullermoney remains long-term bullish, not least because of the accelerated rate of technological innovation which I have often mentioned. However, in the short-term, US stock market indices are overbought and due for a reaction and consolidation. Moreover, there is the big medium-term hurdle of quantitative easing (QE) tapering. We should not overlook Jonathan Weil's two most important sentences above: "The Fed could stop the music at any time with one stroke", and: "If the Fed can't spot signs of bubbles forming now, that's because it doesn't want to."
For a preview of the next big shakeout, look at some of the ASEAN Indices which led the stock market recovery: Thailand, Indonesia and the Philippines.
Lastly, helpful notes of caution in overvalued or at least overextended markets come early. I am not bailing out and I am not suggesting that you should bailout. However, we all need to strive for objectivity. It pays to run with trends which remain in form, but we should also recognise that the short to medium-term environment is becoming more speculative. That will help us to keep our feet on the ground.