Are We Witnessing a Stock - or Bond - Market Bubble?

I’ve had more than one conversation over the past few months with people wondering if the stock market is creating another bubble just waiting to pop. There are many reasons to believe it. We’ve gone nearly three years without a 10% correction. The Shiller P/E ratio has only been this high in 1929, 1999, and 2007, on the eves of major market crashes. The Dow and S&P 500 just hit major milestone levels of 17,000 and 2,000, respectively. The S&P 500 has averaged returns of more than 22% over the past three years. How can we not be in a bubble?

The biggest reason I think the stock market—in general—is not grossly overvalued is because of interest rates. There are—as there have always been—pockets of craziness (e,g, Netflix). I will caution that I think the market is not undervalued at today’s levels. But given 10-year U.S. treasury bonds yield 2.5%, there are not a lot of alternatives to stocks and real estate when reaching for “decent” returns on your money.  

We live in a world awash in fiat money printed by the central banks and treasury departments of the developed world via “Code Red” quantitative easing programs, and deficit spending. The $3.5 trillion that the United States Federal Reserve has magically printed into circulation since 2009 has to be invested somewhere; and no investor in their right mind would loan the Spanish government money for ten years, only to be paid less than the 2.5% that the U.S. government would pay on similar terms.

My theory is that as long as global interest rates on 10-year developed market government bonds stay below 3%, I will have a hard time considering stocks generally overvalued until the forward P/E ratio (currently 16) of the S&P 500 pushes above 24. That leaves room for an additional advance of 50% in stocks.

Given the low interest rate environment, I’m more inclined to postulate that we’re in the midst of a bond bubble. With yields on corporate bonds seemingly unable to push lower, I feel prices of corporate bonds have peaked. If you’re satisfied with 2% yields on 5-year A-rated bonds, you can buy bonds today. I’d rather take measured risks in other areas to attempt to beat 2% over the next five years.

Over the past year, we’ve been shifting assets from client bond allocations to more “alternative” income sources like real estate investment trusts, oil and gas infrastructure MLPs, and option income strategies—while maintaining a steady dose of stocks in client equity allocations. 

“This time is different” is a scary phrase to use, but until interest rates rise, I think it is.