We often hear the word “bubble” thrown around when people are taking about various financial markets, asset classes, and sectors. But just what does the word really mean? In looking at the various definitions of an economic or speculative “bubble” you see a few main themes. First, a bubble typically entails a rapid expansion followed by a swift retrenchment. Second, a bubble implies security prices moving much higher than is warranted by fundamentals or the intrinsic value of the security. Additionally, a bubble encompasses a belief that demand for the securities and the security prices will continue to rise—until the bubble bursts.
Recently we have seen market pundits and the media cavalierly throw around the word “bubble” when taking about equity markets in general, the IPO market, biotech equities, Chinese equities, and even our own high yield market, among others. Yes, we have seen a large rise in these various markets off their bottom, but you need more than a rise in a market to constitute a bubble. As the various definitions of the word note, a bubble is when we see the prices rise dramatically above what is warranted by fundamentals or a security’s true/intrinsic value. That means that a price rise alone doesn’t justify a “bubble,” but it must be measured against some sort of valuation methodology.
First, let’s look some valuations in the broad equity sector. In terms of the equity market, P/E ratios are a common way to view equity valuations. If we look at a trailing 12-month S&P 500 P/E ratio going back to 1957, we see the current ratio is 20.2x versus a historical median of 17.42x.1
While this is a trailing 12-month PE ratio, let’s look at a forward 12 month P/E ratio2, as we know markets are often forward looking mechanisms:
Here we currently sit at 16.7x versus a 10-year average of 13.8x. So by these valuation measures, the S&P does look expensive. For instance, on the forward P/E, it is worth noting that we are higher than where we were going into the 2008 financial crisis. Does this qualify as a “bubble”? Expensive, certainly. Due for some sort of correction? Likely. But a completely “bubble”? That case is a little harder to make, as looking at the nearly 60 years of history, while we are above the median levels, we are not near the extremes. And even in an expensive broader market, that doesn’t mean that active managers are not able to select a focused portfolio of 50-100 individual securities that still offer investors value. We believe it is during these sort of times that active management has the most value.
Turing to the high yield market, looking at spreads is a good way of looking at market “valuations.” Below we profile a nearly 30 year history of the high yield market:3
So currently we sit at a spread (spread-to-worst over comparable Treasuries) of 539bps, a little bit above the 520bps median over this nearly 30 year period. So how can someone make a “bubble” argument when we aren’t even below the historical median level? Certainly looking at the 2006/2007 period, there was that argument to be made, as we were spread levels sub 400bps and even 300bps, bottoming at 271bps in May 2007 before things started to turn in 2008. On the “fundamental” side, during this 2006/2007 period, corporate leverage metrics were elevated and management teams were aggressive with their spending. M&A deals were being done at ridiculous multiples with buyers putting in very little equity, further adding to corporate leverage. Yet, spreads continued to grind lower, until investors woke up to the reality and wanted to get paid for the risk they were taking. And then, as in many market “adjustments,” we saw the market over-correct in 2008/2009. Today, we are back around historical medians, despite a well below average default rate, reasonable fundamentals in the underlying companies, and what we would view as generally conservative management teams. Today we believe investors are getting adequately compensated for the risk they are assuming.
Another aspect we often see in “bubble”-like markets is that they are basically a one-way trade up, as investors seemingly ignore reality and valuations, until the market crashes into free fall. However, over the past several years in the high yield market, we have seen various periods of spread and yield tightening, followed by sells offs and spread/yield widening.4
This natural ebb and flow would certainly indicate to us that investors in this space are at least reacting to changing market conditions and dynamics, which we see as healthy.
Finally, generally a “bubble” implies people blindly throwing money at the sector in a frenzied buying spree. Be it bubbles from hundreds of years ago, like the tulip bubble, or the more recent dot-com or housing bubble, we saw investors piling into these areas with the mentality that these markets would only go up. However, we see no such mania in today’s high yield market. In actuality, we have seen only $1.2 billion in inflows into high yield mutual and exchange traded funds so far this year, this after over $20 billion in outflows from the space in 2014.5 Definitely no manic buying here.
So broadly speaking, we don’t see the high yield market as expensive, much less in “bubble” territory. Yes, there are individual credits within the space that we see as over-valued, trading at yields that we don’t believe compensate investors for the risk in those securities, but as active managers, we are able to avoid these areas. Addressing and managing this risk can come in the form of not purchasing high duration/low yielding credits that expose investors to much more interest rate risk. Or it can take the form of avoiding highly levered companies or sub-segments of the space where we have fundamental concerns or questions about the company’s long term ability to service their debt, such as the concerns we have been vocal about with many of the shale-related energy producers that are large issues within the high yield market.
While there are certain areas of the financial markets, such as equities that we see as expensive, and maybe even some areas globally where the word “bubble” may apply, such as the massive run up and swift re-pricing we have seen in Chinese equities over the past few weeks, we view today’s high yield bond market attractively valued, and nowhere near a “bubble.” We have been managing money in the high yield bond market for over two decades and have seen a variety of market cycles. There have been times in the cycle where everything seemed expensive and in order to get any sort of yield you had to take on excess risk. That is not today’s market. As an active manager, we believe there are plentiful opportunities to build a focused portfolio of attractively yielding high yield bonds and loans, without taking on excessive risk.
1 Data sourced from wwww.multpl.com, “S&P 500 PE Ratio” covering the period 4/1/1957-6/29/2015. Current PE is estimated from latest reported earnings and current market price.
2 FactSet, “Earnings Insight,” June 26, 2015, p. 25.
3 Data sourced from Credit Suisse, as of 6/29/15. Historical spread data covers the period from 1/31/1986 to 6/29/2015. The Credit Suisse High Yield Index is designed to mirror the investible universe of the $US-denominated high yield debt market. “Spread” referenced is the spread-to-worst.
4 Data sourced from Credit Suisse, as of 6/29/15. Historical spread-to-worst and yield-to-worst data covers the period from 7/02/2012 to 6/29/2015.
5 Acciavatti, Peter, Tony Linares, Nelson R. Jantzen, CFA, Rahul Sharma, and Chuanxin Li. “High Yield Market Monitor,” J.P. Morgan North American High Yield Research, January 5, 2015, p. 7. First half numbers provided by various market sources.