Investors are ignoring sky-high stock valuations and downplaying the potential for a stock market bubble

DAVID MACNICOL
SPECIAL TO THE GLOBE AND MAIL

Opinion: With CAPE ratios near dot-com highs, FOMO has replaced the discipline of asking whether prices are fair

There was a time when investors cared about valuations. Analysts and commentators debated price-to-earnings ratios, price-to-book ratios and the sustainability of stock prices. Investors had a plan when it came to which stocks they bought, at what price and why, typically avoiding excessive valuations.

These days, something curious has happened. With the advent of passive investing and robo-advisers, the framework that once governed sound investing is almost forgotten. The mainstream consensus among many investors and strategists appears to be to downplay high valuations and the potential for a bubble. Current cyclically adjusted price-to-earnings (CAPE) ratios are about as high as at the peak of the dot-com bubble in the late 1990s, but few seem to care. The elephant is still in the room, but most investors seem to be ignoring it.

The bull market that began in the aftermath of the Great Financial Crisis has now lasted more than 17 years, interrupted only briefly by a global pandemic (in 2020) and the fastest relative rise in interest rates on record (in 2022). Ironically, it may be remembered as one of history’s most disliked bull markets. Investors and commentators spent years plagued by the recency bias of 2008, cautious about the next debt crisis, a wrong U.S. Federal Reserve move, the next recession or the next geopolitical shock. Yet, in the face of the Euro debt crisis, the Fed’s view that inflation was “transitory,” a technical recession in 2022 and two open wars that many thought would bring about the end of days, markets have continued higher.

Perhaps this is why today’s valuations no longer provoke the discussion or criticism they once did; value investing (and the framework that governs it) has gone so much out of favour that only the oldest and most fearful investors adhere to it, watching managers who are barely out of business school (if that) make more money in a year than they did in their lifetimes. Investors now laugh at those who remain married to fundamentals, having spent the past decade and a half warning about a crash that has yet to come.

What was once an extraordinary aberration bound to be brought back to earth now feels like the norm. But it shouldn’t. Many of the valuation measures that investors traditionally relied upon now sit at levels that would have generated widespread concern 25 years ago, and indeed did, leading to the dot-com bubble and crash. The difference today is not that prices have become more reasonable, it’s that we are collectively ignoring price and valuations.

The past 17 years have seen numerous reasons to justify markets pushing higher; artificial intelligence is just the latest one. To be clear, AI is likely to transform the global economy and our way of life. Few technological advances have generated as much genuine excitement or attracted as much investment. But somewhere along the way, discussions about the technology began replacing discussions about price. A remarkable company is not automatically a remarkable investment, especially at lofty valuations. A revolutionary technology does not exempt investors from the mathematics (and reality) of valuation. The dot-com era taught precisely this lesson. The internet ultimately changed the world far more profoundly than most people imagined, yet many investors still lost fortunes by paying extraordinary prices for admittedly extraordinary businesses, but extraordinary businesses that were already priced to perfection.

History has a way of repeating itself, although almost never in identical fashion. Today’s enthusiasm may ultimately prove justified. Corporate earnings have been strong (compared with the dot-com mania) and could continue growing. Productivity gains from AI appear real and could exceed expectations as the technology grows. Perhaps current valuations will look perfectly reasonable in hindsight. But investing has never been about certainty; it’s been about mathematical probability.

Instead of investors asking whether an investment is fair value, investors are asking whether they can afford to miss out. Fear of overpaying has steadily been replaced with the fear of missing out (FOMO). The reason investors are more bullish now than ever, even at these valuations, is because being bullish is what has worked: In the face of pandemics, wars, recessions and inflation, everything bullish has worked. Therefore, investors are not working within a valuation framework, but a behavioural one.

The longer markets rise, the easier it becomes to assume they should continue rising. Eventually, elevated valuations cease to look elevated because investors have forgotten what normal looked like in the first place. That, more than earnings multiples or market data, may be the real elephant in the room.

Markets do not ring a bell before sentiment changes. They never have. Expensive markets can become even more expensive, just as pessimism can linger long after bargains appear. Valuation has always been an imperfect timing tool. It remains, however, one of the most reliable measures investors possess. Perhaps this is why thoughtful investing feels harder today than at any point in recent memory. The old rules appear less certain and the new rules make money without a second thought. Traditional valuation metrics compete with technological optimism, passive investment flows and narratives that seem to justify almost any price.

When almost everyone is comfortable with the elephant in the room, the hardest task is simply acknowledging that it is still there. But those who do so will be prepared for when that beast finally wakes up and disrupts the party.

David MacNicol is president and portfolio manager at MacNicol & Associates Asset Management. With more than 40 years of capital markets experience, he oversees investment strategies focused on risk management, alternative investments and portfolio protection strategies for high-net-worth clients and institutions in North America.