Is An Equity Bubble Brewing?

Every day, you’ll find another take on what the state of the equity markets are and what the future might hold for them.

Credit Suisse (NYSE:CS), a multinational financial services holding company, chimed in this week and said they believe that there could be a 60%-70% chance we end up in an equity bubble in the medium term, albeit with the inevitable road bumps along the way.

In the report, Credit Suisse said: “Bull markets in most assets end in bubbles; despite Fed tightening this year, central banks are likely to keep policy abnormally loose and the dollar might do the majority of the tightening.

Credit Suisse also noted that “an equity bubble developed two years after the last two supply-driven oil shocks (1985 and 1998); retail and institutional involvement in equities has been abnormally small in this bull market to date; and, above all, corporates are under-investing.”

Sam Stovall, U.S. Equity Strategist for S&P Capital IQ said: “As for a bubble, valuations are already at or above fair value. Today’s P/E is equal to what it was in September of 1987, however inflation is currently well below what it was then (1.8% today vs 4.0% then). He added that the “Fed says they want inflation to be at or above 2% before they start raising rates.”

One barometer that could lead one to believe a bubble may be coming would be the good news for the economy and the markets that has been occurring as of late.

Credit Suisse noted that U.S. and global earnings revisions have troughed, credit spreads are much better behaved, multiples and inflation expectations are recoupling, a hard landing in China appears to have been postponed, and there are signs the U.S. economy is accelerating.

And the upswing in the equity markets over the last several years adds to the fact that a bubble may be on its way. In fact, the S&P has risen steadily since March of 2009, to an all-time high this year of 2130.82 on May 21.

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“I would say that bull markets are always followed by bear markets, but this doesn’t mean that the end phase of every bull market is a bursting of a bubble," noted Mike Englund, Chief Economist of Action Economics said. “Fundamentals can drive prices up for a period of time but then turn more negative, and allow prices to drop back. I would argue that this is the usual case."

According to Credit Suisse, there are several general factors that could lead us to the “bursting of the bubble”. Some of those are: when a new concept appears which is used to justify buying in spite of fundamentals; earnings become irrelevant; M&A tends to surge, peaking around 8 months before a peak in equities; and overinvestment.

Englund believes Credit Suisse makes some valid points and his “sense is that stocks have a few more good years" in them before prices switch course. However, he believes this price pattern isn’t dependent on any “bubble” in prices, or any bursting of a “bubble” later.