Featured in the Financial Times - What makes a bubble a bubble

Robert Armstrong, the FT's US financial commentator and author of the Unhedged newsletter, referenced the results of our 2024Q4 Asset Allocation Survey in his article on US exposure, the valuation gap between US and European shares and the indicators of a US bubble.

The America bubble, part II  Yesterday I wrote that US stocks were in a bubble, but that the bubble is more likely to expand further than to pop in the foreseeable future. Today, I’ll argue that this is a specifically American bubble, not a bubble in tech stocks that happen to be American. And then I’ll argue that saying “it’s a bubble that is not about to pop” is actually saying something, not just emitting a journalistic noise that has no actionable implications.

On Tuesday, we pointed out that there is a historically large valuation gap between US and European shares, even when the Magnificent 7 big tech stocks are excluded (I’m using Europe as a simple proxy for “cheap global stocks” here; the argument should be transferable). But it is still possible that the value gap between the S&P without the Mag 7 and the S&P Europe 350 is due to different sector weights. The S&P 493 is, for example, 17 per cent tech by market cap; the Europe 350 is just 7.5 per cent tech. This must be part of the explanation of the value gap. Of course if Europe had more large growing tech companies, its stock markets would be worth more. But it’s not all of the explanation...

In almost all the sectors with big valuation gaps, there is a gap of at least a few percentage points in expected near-term growth. Sometimes the gap is much bigger; European utilities and financials are not expected to grow earnings at all in the next few years.

The question, as we argued yesterday, is whether that growth gap, of perhaps 2-3 percentage points overall, justifies a historical valuation discount of 40 per cent (for markets outside of Europe the growth and valuation gaps will be somewhat different). If the US actually delivers 2-3 percentage points of growth over Europe forever, a 40 per cent premium is likely justified. But the US might not deliver that in 2025 and 2026 — that is, analyst estimates may be too high — and global growth rates seem likely to converge over time.

But just saying the valuation gap is too large in relative terms does not make a bubble. Bubbles are also characterised by high absolute valuations, and they have to be accompanied by very strong sentiment.

The absolute valuation box is checked. Robert Shiller’s cyclically adjusted price/earnings ratios, both adjusted for interest rates and unadjusted, are at the very top end of their historical ranges (though not quite as extreme as in 2000). The S&P 500 equity risk premium, as calculated by the valuation maven Aswath Damodaran of New York University, is at 3.85 per cent. When I interviewed Damodaran earlier this year, he said: “My red zone, usually when I start to get worried, is when [the ERP] hits 4 per cent and starts going below that.”

On sentiment, we may have a little way to go, but not much. Citigroup’s Levkovich sentiment index has moved into euphoria territory, but was actually briefly higher in 2021. The Bank of America asset managers survey shows that after Donald Trump’s election victory, the portion of managers who were overweight US stocks moved to an 11-year high. The proportion of respondents to the Absolute Strategy Research investor survey who expect US equities to outperform the rest of the world lept by 11 per cent, to 63 per cent, after the election. That is the highest level in the decade-long history of the survey. The AAII retail investor survey shows sentiment steadily improving over the past two years, and now sitting at the top of its cyclical range.

Article in full: https://www.ft.com/content/c49e5394-5798-4e51-ab0a-d1517b89d741