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'Is This a Stock Market Bubble?' Is the Wrong Question to Ask


The real issue here is what this historic rally portends for future returns.

In December 1996, then Federal Reserve Chairman Alan Greenspan gave a speech in front of the American Enterprise Institute and posited what the central bank should do when investors' "irrational exuberance" pushed asset values to a level that would compromise future returns:

"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?"

At the time the S&P 500 (INDEXSP:.INX) was trading at 757 and was up 72% from December 1994. Ultimately Greenspan did nothing to curtail this exuberance, and stocks would go on to rally another 61%% into the 1998 Long Term Capital Management hedge fund implosion.

Greenspan "came to the rescue," introducing his eponymous put option. After be given the green light, stocks went on to rally another 68% into the 2000 highs that culminated with the technology bubble blow-off top. These years would see some of the most robust financial returns in history, but as we now know, this was at the expense of returns during the decade that would follow.

Fast-forward to this week's Janet Yellen Senate confirmation testimony where Republican Senator Mike Johanns of Nebraska asked Ms. Yellen, "What am I missing here? I see asset bubbles." Ms Yellen's response was, "We have to watch this very carefully, but I don't see this as an asset bubble." This exchange prompted Wall Street Journal writer Joe Light to ask the question on every equity investor's minds: Is This a Bubble?

It seems the stock market goes up every day, and the more it rallies, the more we hear about the prospects of a bubble. Bulls will tell you we aren't in a bubble because valuations remain modest relative to history, especially when compared to previous stock market bubbles. Bears will tell you we are in a bubble because assets are being artificially inflated by the Fed's quantitative easing and zero-percent interest rate (ZIRP) policy. I would say that asking whether we are in a bubble is asking the wrong question. The real question equity investors should be asking is what this historic rally portends for future returns.

In December 2011, McKinsey & Co. published a thorough study of the equity market titled The Emerging Equity Gap. It included a chart of rolling 10-year annualized equity total real returns using the Shiller S&P composite index. The chart included 10-year annualized returns dating back to 1881, and there was a definable bell curve-like distribution between 17% on the right tail and -4% on the left tail with a median return of 7%. At the time, McKinsey wanted to show that the negative 10-year returns during 2008 (-4%), 2009 (-3%), and 2010 (-1%) were in the left tail and thus very rare in history. However it is the right tail of the distribution of 10-year annualized returns that I think investors need to be aware of today.

Last week in Monetary Policy Myths Debunked, I highlighted the disparity between economic and market performance:

"The vast majority of market participants believe the 10-year Treasury yield is at this 2.50% level because of quantitative easing. But think about the economic benchmarks for growth. The growth rate of nominal GDP is around 3%. The growth rate for consumption is around 3%. The growth rate for inflation is around 1.8%. The growth rate in wages is 2.2%. The growth rate for S&P 500 revenues is 2.9%. With the exception of recessions, these growth rates are among the lowest in the last 50 years.

"On the flip side, equity market gains are among the best in the last 50 years. As the stock market approaches year-end, the S&P 500 is due to log one of the best five-year average annual performances since 1950. If the market closes near recent highs, the five-year average annual growth rate of 14.8% ranks in the top 10 with only four periods in the late '90s and two in the '50s besting the performance. However when measuring against the same five-year average annual economic growth rate of 2.4% the performance of the market is number one over the time frame."

These five-year periods in the late '90s and '50s that bested the past five-year returns were all in the right tail of 10-year periods, so there is no doubt that this equity market is working on a historic performance. As I point out, though, when measured against economic performance, it is the best in the last 60 years. The question is whether it can continue. What are your 10-year average annual returns going to be at this time in 2018?
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