US equities have hit record highs. This is despite Covid-19 continuing to cause disruption and many countries facing a deep recession. Is this an indication of an asset price bubble?
Asset price bubbles are caused when prices rise above their fair value and can often be explained by behavioural finance theory. Common investor biases - such as groupthink, herd behaviour and the oft cited Fear of Missing Out (FOMO) – can take control of logical investment theory pushing prices higher. There are hints that this might be taking place now.
The key drivers of the recent rally in stock prices are:
- Government and central bank stimulus
- Technology stocks
Government and central bank stimulus
Governments and central banks have recently injected huge amounts of money into their respective systems, a lot of which has been pushed into assets and has caused prices to increase. Considering that Covid-19 does not appear to be disappearing anytime soon, it is likely that more stimulus measures could be introduced to keep the economies propped up, causing asset values to increase even further.
Central banks cut interest rates to support the economy throughout the pandemic. Whilst this will be of help to businesses and some individuals, it has caused asset values to increase. Lower interest rates reduce the cost of capital borrowing for companies and increase profits, which results in a higher stock price. Lower yields make it harder to generate a return, which pushes investors into riskier areas of the capital markets, such as equities, causing that price to increase.
The main US equity index S&P 500 is currently up around 58% since it bottomed in March; however, much of this gain has been concentrated in several tech stocks which have benefitted from Covid-19 with people locked down and in need of technology. Key winners include Facebook, Amazon, Google (Alphabet), Apple and Microsoft. Apple was recently the first US company to hit a market value of $2 trillion, only 18 months after being the first to be valued at $1 trillion. Is this rapid increase sustainable?
Why investors might have cause for concern
How much further can stocks rise? There are many challenging issues facing investors which could cause sentiment to change and, therefore, a sudden decline in prices, such as:
- a Covid-19 second wave
- US elections
- US-China trade relations
- high equity valuations (particularly in the tech sector)
- surging levels of government debt
Central and government bank stimulus has caused many assets to increase in price at the same time. However, could they all decline at the same time? This could cause traditional portfolio construction to fail with defensive assets not protecting capital. It happened in March 2020 and could happen again.
Many risks are hard to control, but it is important to be aware of these risks and have realistic expectations of future outcomes. Trustees should work with their advisors to review their investment strategy and ensure it remains suitable.