Markets & Economy
Are we in a market bubble?
January 09, 2014
Rebecca Katz: I think probably the most popular question, and we have it here from Steven in Media, Pennsylvania, was, "Are we in a bubble right now?" I think he's talking about the financial markets.
Joe Davis: Sure, I mean it's funny Rebecca, because we're in the process of updating and publishing our annual economic investment outlook, and that's something that very much weighs on our mind here at Vanguard. I think just to set the framework, what a bubble would generally characterize is asset prices being significantly higher than what their fundamentals would dictate that they are—so the classic example more recently, were tech-company prices in the late '90s or even housing prices in 2006. Ultimately, we are hard-pressed to identify clear obvious examples of bubbles, either in the fixed income market or in the equity markets. But that said, we are significantly concerned, I would characterize, of "frothiness" in the equity markets. Performance has been very strong. It's something that we were optimistic that could occur since the onset of the global financial crisis.
But it's really been the very strong performance of equity markets this past year relative to what the fundamentals have done, such as earnings and corporate profitability—all solid—but prices have extended well beyond that. So it's one where we're not, I would say, bearish, but I think we're of the mind that the expected returns for balanced portfolios, potentially. For the next year, who necessarily knows, but for the next five or ten years are going to be partly lower than where they would have been even four or five years ago. So again, given the strong recent performance, I think we should be prepared for somewhat lower returns going forward.
Rebecca Katz: You talked about stock market, bond market. What about, I know, real estate comes up a lot?
Joe Davis: Real estate—again, I think one of the hallmark characterizations of any asset being in a bubble generally have three characteristics. One is very strong recent performance. Second is strong investor interest or cash flows in that market, and then finally, hard-pressed to explain the performance relative to fundamentals.
When I look at an area such as commercial real estate or housing, again, there are pockets of frothiness in some parts of the country, some types of real estate. But again, I think part of that is just a re-equilibrium from being very below market values of the past several years. I wouldn't characterize real estate as a bubble. Some markets again showing some frothiness.
Rebecca Katz: Okay, so just a pendulum swing.
Joe Davis: It's a pendulum swing, yes. We really spend a lot of time looking at measures of valuations. And why that's important—this is not in any way a sense of a market call so to speak—it's time to get out of stocks, time to get more into stocks—this is really around, for all of us as investors, looking at our portfolio, what is a reasonable range of returns for those assets that we invest in?
Historically, equities over a very long period of time, on average, have provided around 9% or 10% return before inflation. So that's fairly strong. That clearly has rarely happened, if ever, in any one year. And so we look at valuations to get some sense if 9% or 10% is really a reasonable barometer for those sort of returns. Where we look at valuations today, they are at a level that are higher than normal, which means the market's anticipating either higher earnings growth to justify recent performance, and so more likely than not, the odds are starting to tilt towards potentially positive returns over the next five or ten years but just at a lesser pace or rate than what we've perhaps have seen in the past four years where the equity market has more than doubled, or even the past eight or nine years where the return's been 9% or 10%.
Rebecca Katz: When you talk about valuations, you're talking about things like price-to-earnings ratio or price-to-book—
Joe Davis: Price-to-earnings, price-to-book, price-to-sales.
Rebecca Katz: Right now the prices are outpacing the actual earnings.
Joe Davis: Yes, yes and you know—for a classic example, in the late 1990s in the U.S., in the late 1980s in Japan, valuations were extremely high. Conversely, in the depths of the global financial crisis—2008, 2009—valuations were below their historical average, which I recall you and I doing a webcast several years ago saying, "Listen, the economic environment's going to be very challenging like with—you could still be rewarded as a stock market investor. Now, that's turned out to be the case, I think, if anything, and then some.
So it's a little bit more cautious outlook for the markets even though on the economic front, I think there's a little bit more reason for optimism today than there was two years ago.
Rebecca Katz: Good. Less cautiously optimistic and more optimistic than you've been in past webcasts.
Joe Davis: Yes.
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This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.
© 2013 The Vanguard Group, Inc. All rights reserved.
Keep your eye on market fundamentals
Stock prices are in many cases higher than their valuation measures would indicate. Vanguard chief economist Joe Davis says some economic fundamentals are strong but double-digit returns can't last indefinitely.
Other excerpts from this webcast:
- What's next for quantitative easing?
- Joe Davis on risk and return
- Have mom and pop returned to the market?
- All investing is subject to risk, including the possible loss of the money you invest.
- This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.