IN FOCUS6-8 min read

Commentary: Rational exuberance

Alan Greenspan’s famous 1996 phrase ‘irrational exuberance’ is often used when asset prices disconnect from their fundamentals. However, with strong earnings growth and an apparent unshakeable US economy, could stretched US equity valuations be a case of ‘rational exuberance’?

RRF Jan24 commentary


Sebastian Mullins
Head of Multi-Asset

Alan Greenspan famously coined the phrase ‘irrational exuberance’ when discussing the stock market in December 1996. The S&P 500 then went on to double before peaking in 2000, when unprofitable internet companies finally came back down to earth, or in many cases, got buried underneath it. But was Greenspan pre-mature in calling the market irrational in 1996? Despite falling 50% from the 2000 peak, the bursting of the dot com bubble ended in October 2002, with the S&P 500 4.4% higher in price terms than it was when Greenspan uttered his famous words.

Despite the recent 120%+ rally of the ‘Magnificent Seven’ since the 2022 low, it wasn’t the dot com bubble that brought this phrase to mind, but rather when it was said. By now, we all know that the last time the US Federal Reserve achieved a soft landing was in 1995 and only a year later, its architect was warning of irrational asset prices. The S&P 500 rallied 23% that year, taking the Price to Earnings ratio from 15x in 1995 to 19x by the time Greenspan spoke. But the market powered on, rallying another 30% to reach 24x by the end of 1997.

However, this wasn’t just a tech story. The rally was broad based, with the equal weight S&P 500 rallying 25% and the S&P 500 Value index rallying over 27% in 1997. Yes, valuations became stretched and, yes, technology stocks were on a tear, but was this irrational? This rally occurred during an economic boom. From 1995-1997, inflation averaged 2-3% and real GDP grew at 3-4% and cash rates were steady at 5.25%.

Today, cash rates sit at 5.25%, inflation is expected to be between 2-3%, the most recent real GDP print came in at 3.3%. With this economic backdrop in mind, is the forward P/E of 21x for the S&P 500 irrationally exuberant, or rationally starting to price a chance of a 1990s “disinflationary boom”? I intentionally stop at 1997, as beyond that, we get emergency cuts – to avert a financial crisis following the collapse of Long Term Capital Management – during an even stronger economy, setting up one of the biggest asset bubbles of our generation. But before things got really crazy, the market continued to grind higher, front running an ever-increasing economic boom with consistently falling inflation.

Today, the US economy continues to defy expectations, with the recent 3.3% GDP print well above expectations of 2%. Importantly, the price component of GDP slowed to an annualised rate of just 1.5%, well below the Fed’s 2% inflation target. While core PCE is still above 2%, the annualised rate over three and six months are both below 2%. The Fed’s New Tenants Repeat Rent Index has fallen dramatically, pointing to lower shelter costs in the coming months, which is a large component of the CPI basket. Wage growth has also slowed, without any uptick in unemployment. The Fed will cut as inflation falls to prevent real yields from rising, which they confirmed in their last meeting. This ‘disinflation dividend’ will continue to support economic activity.

So, is it time to party like it’s the mid-1990s?

Forward looking data is turning higher; both of the S&P’s flash Purchasing Mangers’ Indices were above 50 in January. The services PMI was 52.9, while manufacturing has recovered from its June 2023 low of 46.3 to 50.3, suggesting a broadening in US economic activity. This improvement in activity is at odds with the uptick in the New York Fed Probability of Recession in 12 months to 63%. However, most recession models focus on monetary tightness, and neither households or corporates are feeling the pinch. Despite the highest and fastest rate hike cycle in decades, household debt service payments as a percent of disposable personal income is at 30-year lows (outside of the COVID distortion). This is because less than 12% of household debt is floating rate (versus 25% pre-2008) and most homeowners locked in 30-year mortgages at around 3%, while their wages grow above 5%.

Consumer confidence in the US is improving. Household balance sheets are holding up, and households’ expected financial situation in six-months’ time is rising dramatically, while their perceived likelihood of a recession in the next 12-months is dissipating. Real wage growth continues, which should support consumption, but coming down from their highs insulating margins. An increase in labour supply has slowed wage growth, avoiding the need for mass layoffs.

While job losses are increasing, they still remain below the pre-COVID average. As most CEOs anticipated a recession, they prepared accordingly, so current layoffs suggest optimising for efficiency as opposed to panicked mass redundancies to support margins as is often seen in recessionary episodes. Housing permits are rebounding, a positive sign for growth given the flow on effects throughout the economy, but also shows consumers are confident in their job security given the commitment of time and money for a new housing project.

CEO confidence is also improving. Despite rising real wages, productivity for the third quarter 2023 grew by 4.8%. Similar to households, corporates maintain a healthy level of cash in the bank, with the S&P 500 cash per share significantly above 2019 levels. Cash per book value has been falling since 2020, but only back to pre-COVID all-time highs. Both household and corporate balance sheets are strong relative to prior recessions and their sensitivity to rate hikes has diminished relative to previous hiking cycles.

While only half the S&P 500 companies have reported, earnings have surprised by 7%, with beats from Amazon, Meta, Microsoft and Apple, but with misses from Alphabet and Tesla. Despite continued talks of expensive US equity valuations and lofty earnings expectations, companies keep surprising to the upside. Analyst expectations are now only 5.5%, which differs from our macro earnings model, which suggests earnings could rise by 12% this year. If economic growth continues, earnings could continue to surprise to the upside.

The market is narrowing in on the soft landing as their base case for 2024, but many investors likely still have a probability assigned to a hard landing as their alternative scenario. With economic growth holding up and inflation collapsing under its own weight, the market may start to shift form worrying about left tail risks, to worrying about missing out on the right tail risk. We still believe a soft landing is the most likely outcome, but it’s hard to ignore the chance a disinflationary boom may be upon us. This will likely support risk assets, pushing up equity prices and valuations higher, as market participants become rationally exuberant.

Portfolio positioning shifts

Our equity allocation increased to 31% delta-adjusted as we added 2% to equities but also bought another 5% notional put-spread, which protects the portfolio until May from a fall between 4700 and 4300 on the S&P 500. In December, we cut our duration exposure from 2.6 years at the Fund level to a low of 1.9 years as yields on US 10-year treasuries fell below 4%. In January, we increased our US dollar position from 3% to 7% on the view that yields will back up given the excessive pricing of 150bps of cuts this year. To keep our Australian dollar exposure mostly unchanged, we sold the Euro and Canadian dollar to fund, keeping our foreign exposure steady at around 12%. After bond yields rose throughout January, we then added back to duration, targeting 2.6 years again at the Fund level, predominantly via US treasury futures.

However, the market is still pricing in 150bps worth of rate cuts by the Fed this year, which we believe is optimistic given our view on a potential reacceleration of growth. With bond yields back down below 4% at the end of January, we will look to trim duration exposure in early February. To hedge the portfolio from a potential increase in growth, we have re-established a 2% position in commodities as well as adding 1% in US energy equities. Commodities remain the only asset class which hasn’t repriced with the soft landing narrative. This was funded by selling 2% in US investment grade and 1% in US high yield. We also switched 2% from US high yield to European high yield where valuations remain more attractive. If we see more evidence of an economic recovery, we are likely to reduce duration and trim credit in favour of equities. We have 10% notional worth of S&P 500 put options to protect the portfolio for any short term volatility in risk assets from a repricing of bond yields to account for higher growth expectations. For now, we remain buyers on dips.

Learn more about investing in Schroder Real Return Fund.

Read the latest white paper from our Multi-Asset team: Characteristics of the ‘Next’ economy and Investment implications of the ‘Next’ economy.

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Sebastian Mullins
Head of Multi-Asset


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