It’s the waning days of 2020, and the U.S. stock market has been on fire, regularly setting new all-time highs. Real estate is also chugging right along; U.S. home prices rose 3.1% in the third quarter alone — the fastest one-quarter growth since records began in 1991.
Other measures of the economy, like the labor market, remain objectively weak. For November, the U.S. Department of Labor reported 10.7 million unemployed, 4.9 million higher than February. On Jan. 31, 2021, a moratorium on evictions and foreclosures affecting 28 million homeowners will expire.
Are U.S. stocks and real estate prices overinflated? Is this just one big asset bubble?
The Contours of an Asset Bubble
It’s not just stocks and real estate writ large experiencing bull markets. Bitcoin recently hit all-time highs above $23,000, with values of the cryptocurrency more than tripling in 2020, a far cry from its $450 value in December 2015.
On Wall Street, special purpose acquisition companies, or SPACs, became the vehicle du jour. Scores of these “blank-check companies,” which are merely sloshing gobs of money for SPAC creators to take private companies public through acquisition, went public in 2020.
Elsewhere in the initial public offering market, DoorDash (ticker: DASH) and Airbnb ( ABNB) went public and quickly reached a combined valuation of nearly $150 billion. Trailing revenue for the two companies was just $5.8 billion, and neither was profitable.
Expert opinions on the current state of the stock market vary.
“I don’t think there’s any question that certain large segments of the stock market are in bubble territory. What you have is a situation where several years’ worth of anticipated growth and future sales and earnings have been pulled forward in today’s valuations,” says Matt Argersinger, lead investor at Millionacres, a Motley Fool service.
Argersinger specifically cites what he calls “technology platform” companies like Airbnb, Okta ( OKTA), Roku ( ROKU) and even Netflix ( NFLX) as having potentially runaway valuations, with other industries like e-commerce and electric vehicles also looking frothy.
“While different in some important respects, today’s stock market really does harken back to the 1990s dot-com bubble,” Argersinger says.
David Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business, disagrees.
Though Kass acknowledges some “extraordinary” post-IPO rallies, he argues that “the companies in question are of much higher quality with much better future prospects in terms of both growth and profitability than the IPOs of the 1999 dot-com era.”
Kass says, “Interest rates in 1999 were considerably higher than they are today.”
And that, perhaps, is the most meaningful large-scale difference between the late ’90s internet bubble and the soaring markets of 2020.
Are Stocks, Real Estate in Asset Bubbles?
At the December meeting of the Federal Reserve’s Federal Open Market Committee, a resounding majority of FOMC participants didn’t foresee rates going up at all by the end of 2022. Most of the committee members expect rates to remain near zero for at least the next three years through the end of 2023.
What follows from low rates, and especially low rates that investors know will stay in the gutters for years, is a natural flow of money into riskier assets.
“Since rates of return on fixed-income investments are at historically low levels, investors have focused on other asset classes such as equities, real estate and cryptocurrencies in order to earn a non-zero rate of return,” Kass says.
It’s not just a benign preference for these higher-risk assets that low interest rates engender. Low interest rates effectively force certain kinds of investors, especially large institutions, into riskier assets, says William Goetzmann, professor of finance and management studies and director at the International Center for Finance at Yale School of Management.
Charitable foundations, for example, “have a mandated 5% payout,” Goetzmann says. “For them to avoid declining in real terms, they really have to invest a lot more into these risky assets.”
University endowments, too, must factor in an annual withdrawal of between 4% and 5% on their total portfolio, leaving little room for 10-year Treasurys yielding less than 1% annually.
As for real estate, few see apt analogies to the 2008 financial crisis, which was driven by a combination of wild speculation, high leverage and shady underwriting standards. Eventually, interest rates, which had been rising for years, combined with those forces to start triggering defaults, setting off its own chain reaction in the world of obscure financial instruments.
Today’s real estate market is much different.
“Housing starts have badly lagged household formation since the Great Recession. And while 2020 was initially looking like it was going to be a strong year for housing starts, COVID-19 put a major dent in construction activity,” Argersinger says.
“With inventories of ‘for sale’ existing homes so low in many markets, there’s a real demand-supply imbalance that favors higher home prices, irrespective of today’s historically low interest rates,” Argersinger says.
“Is a run-up logically followed by a decline? The good news is that a big jump up in price is not regularly followed by a decline in price,” says Goetzmann, who has studied how markets across the world perform after doubling in price.
“I would avoid looking for a red flag” to indicate the top of the market, Goetzmann says. He argues that the market is well aware of past bubbles and that this knowledge is already incorporated into prices.
While the belief in efficient markets can always be used to justify current prices, the more compelling case for why stocks and real estate aren’t in an asset bubble is the interest rate environment and unprecedented support from the Fed. In addition to seeing years of low rates, the Fed also announced it would continue its $120 billion per month bond-buying program for the foreseeable future.
Record-low mortgage rates, as well as a very real housing supply shortage and record-high household net worth all offer legitimate reasons for the recent rise in home prices.
In the stock market, one telling measure of how attractive stocks are as an investment is the spread between the dividend yield of the S&P 500 and the 10-year Treasury yield.
The higher the Treasury yield is when compared with the S&P 500 dividend yield, the less attractive stocks look. Currently, the 10-year Treasury yields about 0.9% to the S&P’s 1.62% yield. Stocks yield comfortably more than government bonds.
At the market peak in October 2007, the 10-year Treasury yielded 4.7% to the S&P 500’s 1.9% yield. At the peak of the dot-com bubble, a 10-year Treasury paid 6.45% to the 1.17% yield of the benchmark stock index.
There are certainly pockets of irrationality in markets, evidenced by the flurry of SPACs and euphorically priced IPOs in 2020. But assets at large have plenty of justification for their current levels — even if much of that justification comes from the central bank and elevated fiscal spending instead of more organic growth.
“We can use the word ‘bubble’ for this,” says Peter Davies, CEO of Jigsaw Trading, “as long as we don’t then assume it has to ‘pop’ soon.”
For cautious investors, the disconnect between Main Street and Wall Street may seem too jarring to accept. But until interest rates start ticking back up meaningfully, there’s little to stop prices from trending higher over the next several years.
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