3 Scenarios for the Next Bubble

While stocks are not in a bubble today, inevitably a bubble will form at some point. Some say you can't spot abubble when you are in it, largely because of disagreements over what constitutes fair value. The Risk

Premium Factor Model can identify bubbles by comparing actual to intrinsic value.

I define a bubble as the stock market, the S&P 500, sustaining a 20% overvaluation for several monthsfollowed by severe corrections. By this definition, bubbles are rare events with only two bubbles since 1986:

March 1987-October 1987 where valuation peaked 64% over fair value1.

February 1999-August 2000 where valuation peaked 48% over fair value2.

Under this definition, it is not a bubble when the market crashes due to recession or other events. For

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Steve Hassett, The Risk Premium Factor (7)

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3 Scenarios For The Next Bubble

Jan. 25, 2014 1:43 AM ET | by: Steve Hassett 12 comments | Includes: BXDB, BXUB, BXUC, EPS, IVV,RSP, RWL, SDS, SFLA, SH, SPXU, SPY, SSO, TRND, UPRO, VOO

Disclosure: I am long SPY and short long-term treasuries. (More...)

3 Scenarios For The Next Bubble [SPDR S&P 500 ETF Trust, ProShares... http://seekingalpha.com/article/1967291-3-scenarios-for-the-next-bubble

1 of 10 1/26/2014 8:31 AM

example, 2009 was not a stock bubble, since the market declined when the popping of the housing bubbletriggered a severe recession. The market decline was actually consistent with economic expectations. Another

period of overvaluation from May 1991 to November 1992 was also not a bubble since predicted valuations

caught up with the actual as interest rates declined and the economy improved. The latter period will bediscussed at the end of this article.

Establishing Intrinsic Value

Obviously, determining overvalue requires the establishment of intrinsic value. Financial assets produce cashflow and that cash flow can be valued. The price of bonds fluctuates directly with interest rates and perceived

risk. The prices of equities are based on future projected cash flow, interest rates and risk. At any point in

time, we can estimate the intrinsic value of equities and determine whether they are in a bubble.

About The RPF Model

The Risk Premium Factor Model (RPF for short) is used to determine the intrinsic value of the market to help

identify bubbles or buying opportunities. (If you are a regular reader, the inset material below will befamiliar.)

Determining whether the market is fairly valued is simple matter of looking at its price relative to

earnings and the P/E ratio. The Risk Premium Factor (RPF for short) Model shows that the fairvalue P/E ratio at any point in time is determined relative to long-term interest rates and not

based on a simple historical long-term average as some would argue.

Determining whether the market is fairly valued is simple matter of looking at its price relative toearnings and the P/E ratio. The Risk Premium Factor (RPF for short) Model shows that the fair

value P/E ratio at any point in time is determined relative to long-term interest rates and not

based on a simple historical long-term average as some would argue.

In short the model says that:

Intrinsic Value of the S&P 500 Index =

S&P Operating Earnings / (Long-Term Treasury Yield x 1.48 - 0.6%)

The model shows that equity prices (SPY) move inverse to yield. In this simplified version of

equation, 1.48 is the Risk Premium Factor and 0.6% is the difference between long-term

expected growth and real interest rates. I've written about the model numerous times, so ratherthan repeat my entire overview of the model, you can read about it in my book or on Seeking

Alpha where you can find the expanded equation as well.

Today it shows that the S&P 500 is fairly valued, not in a bubble and priced for continued growthwith higher long-term bond rates already factored in. Fairly valued means that investors can

expect annual equity returns of about 11%. This is a long way from a bubble.

Using a rough estimate of normalized long-term interest rate of 4.5% (2% real plus 2.5%inflation) to adjust for the Federal Reserve's artificially depressing long-term rates by keeping

short-term rates near zero, the model shows the S&P 500 is fairly valued. (If you care to read my

past articles, they indicated that the S&P 500 was undervalued.)

Alternatively, the RPF Model implies the fair value yield on 10-year Treasuries is 4.37%.

The chart below shows predicted versus actual levels of the S&P 500 Index since 1986. Bubbles are indicated


2 of 10 1/26/2014 8:31 AM

by periods where there is a large gap between predicted and actual levels. This also illustrates the stronghistorical performance of the model compared to actual continuing to revert back to predicted levels.

(click to enlarge)

This chart uses normalized yields on Treasuries of 4.5% (2% real plus 2.5% inflation) from August 2011

through the present. It also shows the recent several year period where the S&P 500 was significantlyundervalued.

RPF Model and Bubbles

While the market often deviates from the intrinsic value determined by the RPF Model, it regresses back topredicted values. This makes it a tool for bubble identification. Looking back historically, the chart clearly

shows the bubbles in 1987 and 2000.

The cause of decline in predicted value in the 1987 crash was overall P/E multiple expansion combined withan increase in long-term interest rates from 7.25% in March to 9.25% in October. Instead of declining the

market continued to rise and P/E ratios continued to expand and the stock market continued to rise, until the

bubble popped.

The 2000 bubble was a similar story. Yield on the 10-year increased from 4.6% to 6.2%, driving down the

predicted values but, again, P/E continued to expand. This was further compounded by earnings continuing to

rise despite the NASDAQ bubble having popped in March 2000. The S&P actually peaked in August 2000,bottoming out more than a third lower in October 2001. During this period S&P Earnings declined from 56.79

to 42.02, making this a bubble followed by a recession driven decline.

Possible Causes of the Next Bubble


3 of 10 1/26/2014 8:31 AM

It is almost a certainty that a bubble will develop at some point in the future; since we don't know when, thekey is knowing how to see it. Here are three scenarios that could lead to a bubble:

The fruit of loose monetary policy comes home to roost. As many fear, the loose money policy of the

past several years could lead to a spike in inflation causing the Fed to react and driving up long-termrates in general. Long-term rates at 6% would equate to a predicted value of 1,295 for the S&P 500 -

30% below today's level.

1.

Irrational exuberance and continued P/E multiple expansion. Strong economic growth and reducedunemployment could set the stage for another bubble by making investors over optimistic and driving

the P/E higher. The P/E on operating earnings is about 17 today. If it expanded to 25, it would push the

index up to 2,680 and overvalued by about 34%. This is the fear the Robert Shiller and others haveexpressed. Not that we are in a bubble today, but one could form if the trend of P/E expansion

continues.

2.

The "Perfect Storm" of high interest rates and P/E expansion. The term "Perfect Storm" isoverused, but still applicable to a rare convergence of events. A combination of interest rates rising to

6% due to a strong economy and inflation and P/E expansion to 25 would put the market to be almost

double fair value with a predicted value of 1,295 compared to an actual value of 2,680 for a P/E of 25on today's level of operating earnings.

3.

Before dismissing these scenarios, consider that the S&P has ended 41 of the 337 months since January 1986

above 25 - that's roughly 10% of the time. Long-term interest rates of 6% only require inflation of about 4%and the Fed's willingness to allow them to be set by the market which is what would happen if inflation

spiked. The 10-year yield has ended a month above 6% in 140 months since January 1986. The point here is

not to imply some probability but only suggest that metrics at these levels are not uncommon.

The good news is that bubbles tend to persist. In 1987, a bubble was indicated by the RPF Model for six

months before it corrected. In 1998/9 it persisted for 18 months. The bad news is that using the RPF Model to

exit the market in a bubble will surely cause you to miss the top.

Final Caution - Beware of False Positives

Using this tool also absolutely requires thought and analysis. The output cannot be followed blindly. Most of

my analysis for publication is based on current actual values for earnings and interest rates. During one periodsince 1986, this would have given a false positive for a persistent bubble.

In May 1991, just as the economy was exiting the recession driven by the S&L crisis, the S&P was at 390,

19% above the predicted value of 316. This implied overvaluation persisted until the end of 1992 while themarket rose 17%. Two factors stand out during this period: 1) The economy was in recovery and, 2) 10-year

yields were trending down from 8.06% in May 1991 to around 6% in early 1993.

Incorporating these facts into a sensitivity analysis could have indicated that the market was priced to includeforward earnings and interest rates, and while it may have been overvalued, it was not a bubble.

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More articles by Steve Hassett »

A Quantitative Approach To Spotting An Equity Bubble Tue, Jan 14Record High For Stocks Still Not A Bubble Mon, Nov 25

Stocks Not In A Bubble, Not Even Close Tue, Nov 5

S&P 500 Fairly Valued At Record High With Higher Interest Rates Already Factored In Thu, Oct 24

Comments (12)

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Moon Kil Woong, contributor

Comments (10042)

This model is susceptible to rate manipulation like QE Which artificially lower interest rates to make

equities look attractive based on relative payout values.

25 Jan, 02:14 AMReplyLike6

Steve Hassett

, contributorComments (195)

Moon,

I make the point that interest rates are very much artificially lower right now, so I use and adjusted rate.You are correct that in using this model, you must take into account whether interest rates are a fair

representation or artificially suppressed, but you also must consider whether the market expects them

to resume to a normal rate.

As I have written in the previously, we are in an unusual period where interest rates are artificial so the

market expects them to rise. While the Fed always can have an impact on rates, historically they havebeen perceived to be fair in that a dramatic shift was not forecast on the horizon.

My model assumes that the market looks at rates and assumes the current rate is the best forecast forfuture rates. And that current earnings are the best base forecast for future earnings growth. It also

enables you to test different assumptions with regard to these variables.

25 Jan, 04:33 PMReplyLike1

Moon Kil Woong

, contributor

Comments (10042)

Thanks for mentioning that and encouraging readers to not take these rules of thumb valuation methods

without considering modifications based on the real world scenarios being played out.26 Jan, 12:02 AMReplyLike0

Tagged: Macro View, Market OutlookProblem with this article? Please tell us. Disagree with this article? Submit your own.


5 of 10 1/26/2014 8:31 AM

Barry North, contributor

Comments (114)

Steve, I really like your articles and it is clear there is a lot of intelligent thought going into them. In

short they are a joy to read, hard to fault and I am not about to start now.

I did pick up on and would like to expand on, this point if I may; The fruit of loose monetary policy

comes home to roost, which deals with the domestic, US consequences of QE.

While I don't doubt for a minute that QE has had local US connotations, it has; events of very recent

times are showing that these "fruits" may be coming home to roost from much farther a field and have

far more devastating results. I talk here of EM countries sitting on largely un-hedged US$ loans, thatthey garnered while the going was good. Now that the going is not so good and their exchange rates are,

it seems, slowly grinding them into the ground, as they struggle to repay their US$ loans, could you

comment on the unintended global bad debt consequences of QE?

A NINJA loan is one thing, but multiple countries unable to pay their loans, is another kettle of fish

altogether.25 Jan, 07:54 AMReplyLike1

Steve Hassett, contributor

Comments (195)

Barry,

Your kind words are much appreciated.

I don't disagree with your thesis. I have tried to confine my writing to areas where I have a value addedexpertise. When it comes to predicting the direction of the US or global economy, the secondary effects

of QE, or even S&P earnings forecast, I stay away since my opinions are just opinions, so I yield to

those more expert in those areas, such as you.

Most of what I have written with regard to my model has followed theme that given a set of current

actual or forecasts for S&P earnings or long-term interest rates, what is the fair value of the S&P 500and how does that compare to current. When I use a forward estimate of earnings, I rely on S&P or

other experts.

My three scenarios were not predictions, but simply examples of what could lead to bubble. Your

scenario is another that could lead to a broader market decline. There are many more that could lead to

a market decline.

I think the result of yours is pretty simple with regard to my model. It would lead to a slowing global

economy, possible recession and reduction in corporate earnings. Since lower earnings would lead tolower fair value on the market we would see a decline. You might be able to provide a better analysis of

how deep that could be.



6 of 10 1/26/2014 8:31 AM

Barry North, contributor

Comments (114)

Thanks Jeff, yes I was trying to drag you from your area of expertise to another one. I realize that now.

I guess the catalyst I see looming, EM debt defaults, could well be the event that deflates the bubble

your model finds.25 Jan, 07:49 PMReplyLike0

avolossov

, contributor

Comments (27)

The author of the article wrote: "During one period since 1986, this [model] would have given a false

positive for a persistent bubble."

I can see one more clear false positive for a bubble produced by the model. The graph in the article

clearly shows a bubble (overprice stock market) around 2009/early 2010. According to the blue line onthe graph the market was overpriced by roughly 30% during that period. Yet 2009 was the bottom (not

a peak) and regardless of the erroneous "overpriced" indication produced by the model the market

moved sharply up after 2009.

How accurate is the model?

25 Jan, 11:56 AMReplyLike0

Steve Hassett


avolossov,

The graph is based on actual trailing 12 month earnings. Obviously investors expected earnings todecline significantly then rebound as the market led the model back up. Even with that, when I

published my original article in The Journal of Applied Corporate Finance in 2010, the R squared for

Jan 1986 - September 2009 was 86% or 90% excluding the meltdown period. So even with using onlyactual historical data it performs well.


avolossov


Steve,


7 of 10 1/26/2014 8:31 AM

Thank you for the feedback. R squared of 86% is quite good for a simple model that has only two

parameters to tweak (1.48 and 0.6%). I do understand that any model can become imperfect under

difficult conditions of modeling market in 2009 (when things were changing very fast). However, Ithink that for an exhaustive discussion of model's false positives it's worth mentioning how the model

performed in 2009.

The most interesting conclusion that I found in the article is the following: "Alternatively, the RPFModel implies the fair value yield on 10-year Treasuries is 4.37%". In my opinion 4.37% seems to be a

reasonable number if we imagine that by some magic QE disappears right now and the 10-year

Treasury yield goes up. So it's another "soft" confirmation (for me) that the model is kind of correct(although the conformation is very "soft")


skiman


"Before dismissing these scenarios, consider that the S&P has ended 41 of the 337 months sinceJanuary 1986 above 25"

Since January 1986, the S&P has always been above 25.25 Jan, 02:55 PMReplyLike0

Steve Hassett, contributor

Comments (195)

Skiiman, I should have been clearer that I was still referring to P/E of the index and notthe actual value of the index. Since the previous paragraph referred to a P/E of 25, I thought that was

clear.


Zvi Bar, contributor

Comments (793)

Fruit don't roost. Birds and bats roost. You should have used doves or hawks.


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3 Scenarios for the Next Bubble