Investors' anxiety over potential asset bubbles is reaching fever pitch, but the conditions for a stock market crash – namely, excessive optimism and wildly stretched valuations – are simply not apparent. Problems exist as they always do, but the likelihood of a severe downdraft remains low.
The most common yardstick for stock market value is the price-to-earnings ratio and, on both sides of the border, it doesn't even hint at bubbly conditions. The S&P/TSX Composite Index is trading at 17.5 times trailing earnings, while the S&P 500 goes for 17 times. These numbers are very close to their average levels of the past decade and a far cry from the 175 times that the Nasdaq reached at the peak of the dot-com bubble in March, 2000.
That said, investors learned during the financial crisis that P/E levels are not the whole story; they're right to look deeper into the situation.
There are two frequently cited causes for concern: the frothy Canadian housing market and U.S. corporate profit margins that seem extremely high in comparison to the overall size of the economy. A correction in either area, however, is unlikely to cause another 2008-style stock-market nightmare.
Sure, Canadian home prices have surged, but they are not underpinned by the insane, derivatives-based leverage that caused the U.S. financial crisis. While some mortgage debt may be securitized, we are not building crazily complicated pyramids of collateralized debt obligations. We have not yet reached the stage where banks are handing out NINJA loans to those with no income, no job, no assets. Nor will we.
Importantly, the potential damage from a housing market correction would fall mostly on government, not bank, balance sheets because of the guarantees provided through Canada Mortgage and Housing Corp. Bank-mortgage growth would certainly slow if home prices were to fall and this would be a major hurdle for bank-profit growth. But debt writedowns are unlikely to amount to more than an annoyance for the Big Five.
The lack of derivatives-based leverage and the presence of the CMHC buffer make it almost impossible to see how a housing slowdown would cause the banking system to seize up. The U.S. financial system froze in 2008 because banks didn't trust the solvency of their competitors. The financial strength of Canadian banks strongly suggests this won't happen here.
In terms of U.S. profit margins, the scaremongering is also misplaced. It's true that the low cost of capital engineered by the U.S. Federal Reserve has allowed companies to boost earnings through debt refinancing and share buybacks. It's also true that corporate profits as a percentage of U.S. GDP are extremely high by historical standards.
But for all the hype, operating margins and returns on equity – two of the most widely used measures of corporate profitability – have barely budged. Aggregate return on equity measures for the S&P 500 are actually around 2004 levels, well below the 2006 peaks. Operating margins are a little more concerning, but still broadly in line with pre-crisis levels.
None of this is to suggest that the market will rocket higher. The cyclically adjusted price-to-earnings ratio (CAPE) developed by Yale economics professor Robert Shiller measures the stock market relative to its profits over the past 10 years. CAPE currently ticks in around 25, well above its long-term average, indicating U.S. stocks are expensive.
But Bank of America quantitative strategist Savita Subramanian notes that the current reading is distorted by the plunge in profits during the financial crisis, a once-in-a-generation event. In addition, Jeremy Siegel of the Wharton business school points to some major changes in corporate accounting that could also make CAPE less applicable in the current market.
So long as low interest rates continue to chase investors out of fixed-income alternatives, the worst-case scenario for stocks appears to be a slow grind lower if economic growth disappoints. The only area where excessive valuations and bulletproof optimism have reached a stage where regression to the mean would be really painful is the Canadian housing sector. But here it is taxpayers, not the stock market, that would bear the damage.
The biggest, most measurable market bubble right now is investor fear. Google Trends shows that Web searches for "stock bubble" have reached levels not seen since December, 2007. This anxiety is likely misplaced.
Investor caution is warranted, but no more than usual. The risks of a crisis-style market calamity are minimal. Investors that pick their spots, diversify and keep a cool head should be fine.