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Credit Suisse: Be Wary Of Equity Bubble Forming
Aspire, Investments | 06 July 2015
By: Lim Si Jie
Articles (169) Profile

Stocks in most major economies are currently sitting near record highs with several catalysts in driving prices both up and down. While some investors are arguing that there is still room for upside, others are contemplating about reducing their positions to lower risk exposures.

Credit Suisse is one of the more optimistic firms that believe that stocks will still run, despite the general market to be overvalued. However, it has cautioned that there is a 60 to 70 percent probability that we might end up in an “equity bubble in the medium term”.

Stock market analysts at Credit Suisse added that it is common for “bull markets in most assets to end in bubbles”.

Historical Bull Runs

In previous bubbles, the S&P 500 hit an average Price-Earnings (P/E) ratio of about 28 times earnings, which is an additional 60 percent upside to current levels in the U.S. if there are no change to earnings.

Interestingly, when compared to multi-year bull markets (which have lasted for a median of 18 years with a median real gain in the equity markets of 380 percent), the current bull market in 2009 appears relatively small with a gain of 152 percent in real terms over six years. Most notably, the US market is only seven percent above its previous secular bull market peak.

No Bubble Yet But It Is Forming

Although the market has been jittery about the length of the current bull market, Credit Suisse do not believe that stocks are in a state of bubble right now.

Credit Suisse defines bull markets as any unbroken period without a slump of 20 percent or more. Historically, there are comparable periods that lasted much longer compared to the current bull run.

Source: Credit Suisse

However, the conditions for significant equity overvaluation are falling into place. Credit Suisse notes that it has been a long time since a smaller ten percent correction in US stocks, something that has not happened since back in 2011. Word on the street is that hedge fund billionaire George Soros is building his short position against the S&P 500, in anticipation of a correction.

Source: Credit Suisse

The widening gap between the Chicago Board Options Exchange Volatility Index for stocks (VIX) and the Merrill Option Volatility Estimate (MOVE), which track bonds, is setting the stage for higher prices as the “fear of losing money” is returning to levels in 2009.

Source: Bloomberg

Bubble Checklist

Credit Suisse provided a checklist for investors in times of doubt if an equity bubble is forming or has formed. And based on Credit Suisse’s verdict, a bubble has not yet formed right now, at least not until all of the symptoms in the checklist have arose.

Source: Credit Suisse

Potential Catalysts For Bubble

1. Loose Monetary Policy

Credit Suisse warned that central bankers “will keep rates abnormally low” as they try to figure out whether the fall in core inflation is a reflection of a demand shortfall or supply side driven.

2. Impact Of Oil

Falling oil prices can provide both a boost in consumer spending. On the other hand, it will keep policy interest rates from central banks low as core inflation does not hit the Fed’s target. This is clearly exemplified in the European Central Bank’s Quantitative Easing (QE) policies in response to falling inflation which is largely driven by tumbling energy prices.

3. Rise In Stock Trading

Retail investors are far less sophisticated than institutional investors. They typically buy in more when stocks are relatively expensive (the greater fool theory), providing a boost to bubbly valuations. As of now, retail investors have not rushed back into stocks, except in China.

Si Jie is no stranger to investing having started his journey at a young age. He is heavily influenced by acclaimed investors such as Benjamin Graham, Peter Lynch, and John Rothchild.

Please click here for more information about this author.

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