US Equities: Resilient Force or Case Study in Denial?

Why do so many people, some of whom have solid market pedigrees and even Nobel prizes, believe that markets are in a bubble? The two most common explanations, in my view, reflect a trust in mean reversion, i.e., that markets revert back to historic norms. The third one is a more subtle one about winners and losers in today’s economy, and requires a more serious debate about how economies and markets are evolving. The final argument requires that you believe that powerful rate-setting central bankers and market co-conspirators have artificially propped up stock and bond prices. With each argument, though, there are solid counter arguments and in presenting both sides, I am not trying to dodge the question, but I am interested in looking at the facts.

The simplest argument for a correction is that US equity markets have been going up for so long and have gone up so much that it seems inevitable that a correction has to be near. It is true that the last decade has been a very good one for stocks, as the S&P 500 has more than tripled from its lows after the 2008 crisis. While there have been setbacks and a bad period or two in the midst, staying fully invested in stocks would have outperformed any market timing strategy over this period.

Is it true that over long time periods, stocks tend to reverse themselves? Yes, but when and by how much is not just debatable, but the answers could have a very large impact on anyone who decides to cash out prematurely. The easy push back on this strategy is that without considering what happens to earnings or dividends over the period, no matter what stock prices have done, you cannot make a judgment on markets being over or under priced.

If stock prices had jumped 230% over a period, as they did over the last decade, and nothing else had changed, it would be easy to make the case that stocks are over priced, but that is not the case. The same crisis that decimated stock prices in 2008 also demolished earnings and investor cash flows, and as prices have recovered, so have earnings and cash flows:

Notice that while stocks have climbed 230% in the ten-year period since January 1, 2009, earnings have risen 212% over the same period, and cash flows have almost kept track, rising 188%. Since September 2014, cash flows have risen faster than earnings or stock prices. It is possible that earnings and cash flows are due for a fall, and that this will bring stock prices down, but it requires far more ammunition to be credible.