Why Stock Market Bulls May Be Right to Push Valuations So High
By Jim Ayres and Larry Hood
As seen in MarketWatch
on August 26, 2021
With U.S. stocks reaching new highs, investors and experts alike are starting to wonder if market conditions are getting frothy.
In a frothy market, investor enthusiasm begins to outpace any consideration of risk. Investors feel confident in the economy and corporate earnings and begin to project that confidence further into the future. They increasingly listen to their greed impulse and tune out fear, leading them to bid up stock prices to levels that look historically high and difficult to justify based on the near-term outlook.
Taken to its extreme, this eventually lays the groundwork for a bubble, when investor emotion causes prices to detach completely from valuation. We certainly are not there at this point, so we’ll leave that for another time.
A clear example of frothiness played out in late 2017, when many investors were fully invested in stocks and behaving as though volatility was only going lower. Fear of missing out overtook the fear of losing money and many took on more risk than they probably would have wanted (or perhaps even realized they had) in a more normal environment. Those are classic symptoms of a frothy market.
While there have been pockets of speculation of late — cryptocurrencies, SPACs, meme stocks — we are not seeing the sort of widespread excess in investor enthusiasm that would lead us to characterize the broader market as frothy. Yes, returns have been robust and stocks have risen steadily. One could easily assume that investors have anchored on recent good news and moved into the “greed” phase.
But what if this optimism is justified? Economic growth has been exceptionally strong, driven by pent-up demand and massively accommodative policy, while earnings have rebounded dramatically. Continued growth should bring valuations to a point where they begin to look more reasonable.
Measures of risk appetite, meanwhile, are not extreme; the various risk barometers periodically make a run at exuberance, but there’s still enough to worry about — from a possible Fed policy change to the growing spread of the Delta variant — to put investor emotion back in check before things get out of hand.
In fact, investors’ inability to shake these worries produces an interesting paradox, whereby the largest and most-stable stocks are one of the few areas that might actually be starting to warrant the “frothy” label. Investors feel they have no choice but to own stocks, yet are reluctant to take on risk.
As a result, traditional “risk-on” sectors — small-caps, high-beta stocks, IPOs, for example — have lost steam as investors pivot to their favorite large-cap, U.S. growth companies, which have seen their price multiples and representation in the indexes rise to lofty levels.
At times like this, it can be tempting to chase performance and buy even more of what’s working because “it’s going up.” But like the Hotel California, getting in is not a problem, but getting out may prove difficult as everyone heads for the exit at once.
Risk control
Investors do have options to mitigate the risks that may be developing within this part of the market. While some are turning to “smart beta,” which uses a different index-weighting methodology — such as dividends or volatility (versus the market capitalization-weighted approach used by many indexes) — there is a clear element of market timing in such moves that can materially impact performance.
