Gold News

5 Signs of Stock Market Bubble

Today's leverage tops the list...
 
MOST ANALYSTS agree that the US stockmarket is overvalued on almost any measure you care to use, writes John Stepek at MoneyWeek magazine.
 
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, 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.
 
Finally, 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.
 
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 [earnings before interest and tax] 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.

Launched alongside the UK's highly popular The Week digest of global and national news in 2001, MoneyWeek magazine mixes a concise reading of the latest financial events with expert comment and investment ideas.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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