UBS: Are equities in a bubble?

There are also elements of the rally that are consistent with bubbles according to our framework. The rally has coincided with new participants entering the market: Platforms like Robinhood, which added more than 3 million users in 2020, have contributed to broadening the accessibility of stocks. Retail investors now account for a full 20% of US equity order flow, up from just 10% in 2010, and roughly equivalent to flows from banks, hedge funds, and long-only funds combined.

Options activity and the growth in the SPAC market also suggest a willingness to “buy forward.” Average trading in call options has more than doubled over the course of 2020, and put-to-call ratios are indicative of prevailing bullish sentiment. This is also backed up by equity flows. Global equities recorded USD 46.4 billion of weekly inflows in the week ending 16 December, exceeding a prior record of USD 45 billion, which itself was only set on 11 November. As of 11 January, net inflows into equities over the past three months had reached USD 213 billion.

However, although these signals bear monitoring, we do not think that equities as a whole are in a bubble.

First, although leverage can increase rapidly, it remains contained for now. Persis- tently high levels of equity market volatility through 2020 have helped prevent hedge funds and risk parity funds from adding leverage through the rally, although recently there have been indications that leverage is rising. Meanwhile, margin debt relative to the S&P 500 market cap is at lower levels then the norm for much of the past decade.

Second, we can point to large parts of the market that are not expensively valued by historical comparison. For example, stripping out the FAAMNG stocks (Facebook, Amazon, Apple, Microsoft, Netflix, and Google), the S&P 500 only rose 6% last year.

Excluding IT and the IT-related parts of consumer discretionary the forward P/E for global stocks drops from 20.2x to 17.7x. On a cyclically adjusted basis, P/E ratios are close to, or below, long-term averages in all major markets except for the US, where valuations have been skewed higher by mega-cap tech stocks.

Finally, valuations of equity indexes look more reasonable if we consider the back- drop of low interest rates. Nobel laureate Robert Shiller’s “excess CAPE yield” implies a forward-looking excess return of equities over bonds of around 3.8%, consistent with long-term averages. An equity risk premium (ERP) approach, com- paring equity earnings yields with benchmark yields, shows similar results, with stocks looking cheap relative to bonds.

Of course, collapsing bubbles can, in the right circumstances, drive broader eco- nomic weakness and impact the equity market even if the market itself is not in a bubble. However, the parts of the market that may be experiencing bubbles today (such as cryptocurrencies) do not appear to be highly interconnected with the finan- cial system and are not particularly capital- or labor-intensive. This should limit the broader economic fallout and impact on corporate earnings more broadly, in the event of any individual bubbles collapsing.