Market Bubbles?

A hot topic in the financial markets concerns the potential creation of asset or market bubbles. The bubble believers suggest central banks around the globe are creating market bubbles by flooding cash into their respective economies via accommodative monetary policies. Just this week European Central Bank President Mario Draghi and Federal Reserve Chairman Ben Bernanke signaled they will continue to provide liquidity to their economies. Japan’s new head of the Bank of Japan said easing can be justified for 2013. Bernanke defended the Fed’s action to Congress saying their actions have helped reduced borrowing cost and promoted economic growth.

As you can see from the chart above, all the major stock market indices have benefitted from these accommodative policies. As the S&P 500 and the Dow Jones Industrial Average approach their all-time highs, should they be sold? It is important to view markets on a relative value basis versus an absolute basis. The key question is: are the markets over or under valued? In our 2013 stock market forecast, we expect the S&P 500 to earn $111.00 for the year and a return to a 10-year historical price earnings ratio of 14.3 times. This conservative valuation would equate to an S&P 500 index level of 1,587 and it closed February at 1,515. From here, the questions are; will the market move to an overvalued state (which it usually does) or do earnings continue to grow keeping the market at a conservative fair value? Regardless, we believe the equity markets are fairly valued and do not deserve bubble status.

The concept of a “bond bubble” is receiving even more attention in the media. The term implies a pending doom to fixed income investors. Instead of visualizing an end of the world event, let’s think about the market gradually releasing some air from a slightly over inflated balloon. The key drivers to the future interest rates and credit spreads are: inflation, economic growth and Federal Reserve action. Looking ahead for the next twelve months these key factors appear to be in the bond market’s favor. Low inflation, low to moderate economic growth in the U.S. and a Federal Reserve long-term holding pattern leads to a fairly stable interest rate environment.

For the first two months of this year the 10-year U.S. Treasury Note yielded from 1.75% to 2.05% and finished February near the middle of this range. We expect a narrow trading range in bonds as 2013 unfolds driven by stable moderate economic growth, benign inflation, and an accommodative Federal Reserve. We do not believe the bond market deserves bubble status, but it is prudent to lower your bond return expectations to low single digits, shorten duration and improve the credit quality of your fixed income portfolio.

Remember successful investing occurs over long periods of time. The past four years provided long-term investors the opportunity to rebound from a difficult period. We see the market glass as half full and expect markets to grow as global economies continue to improve. Our recommendation is to stay invested at an appropriate risk level for your situation and reap the rewards of being a long-term investor.

Posted on March 1, 2013
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