Commentary by Joseph H. Davis, PhD, Vanguard global chief economist

Republished with permission of Vanguard Canada

There’s only one sure way to identify an asset bubble, and that’s after the bubble has burst. Until then, a fast-appreciating asset may seem overvalued, only for its price to keep rising. Anyone who has tried to breathe one last breath into a balloon and finds it can accommodate two or three more breaths can relate.

Yale University’s William Goetzmann learned just how hard it can be to pinpoint a bubble. He found that assets whose prices more than double over one to three years are twice as likely to double again in the same time frame as they are to lose more than half their value.¹

Vanguard believes that a bubble is an instance of prices far exceeding an asset’s fundamental value, to the point that no plausible future income scenario can justify the price, which ultimately corrects. Our view is informed by academic research dating from the start of this century, before the dot-com bubble burst.

Are there asset bubbles out there now? We at Vanguard have great respect for the uncertainty of the future, so the best we can say is “maybe.” Some specific markets, such as U.S. housing and cryptocurrencies, seem particularly frothy. U.S. home prices rose 10.4% year-over-year in December 2020, their biggest jump since recovering from the global financial crisis.² But pandemic-era supply-and-demand dynamics, rather than speculative excess, are likely driving the rise.

Cryptocurrencies, on the other hand, have soared more than 500% in the last year.³ It’s a curious rise for an asset that is not designed to produce cash flows and whose price trajectory seems like that of large-capitalization growth stocks: the opposite of what one would expect from an asset meant to hedge against inflation and currency depreciation. Rational people can disagree over cryptocurrencies’ inherent value, but such discussions today might have to include talk of bubbles.

What about U.S. stocks? The broad market may be overvalued, though not severely. Yet forthcoming Vanguard research highlights one part of the U.S. equity market that gives us pause: growth stocks. Low-quality growth stocks especially test our “plausible future income” scenario. For some high-profile companies, valuation metrics imply that their worth will exceed the size of their industry’s contribution to U.S. GDP. Conversely, our research will show that U.S. value stocks are similarly undervalued.

Notes: Data as of December 31, 2020. Portfolios are indexed to 100 as of December 31, 2010. Low-quality growth and high-quality value portfolios are constructed based on data from Kenneth R. French’s website, using New York Stock Exchange-listed companies sorted in quintiles by operating profit and the ratio of book value to market value (B/P). The low-quality growth portfolio is represented by the lowest quintile operating profit (quality) and B/P companies. The high-quality value portfolio is represented by the highest quintile operating profit and B/P companies. The broad U.S. stock market is represented by the Dow Jones U.S. Total Stock Market Index (formerly known as the Dow Jones Wilshire 5000) through April 22, 2005; the MSCI US Broad Market Index through June 2, 2013; and the CRSP US Total Market Index thereafter.
Source: Vanguard calculations, based on data from Ken French’s website at Dartmouth College, mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html; MSCI; CRSP; and Dow Jones.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Low-quality growth stocks — companies with little to no operating profits — have outperformed the broad market by 5.5 percentage points per year over the last decade. Of course, there are reasons why growth stocks may be richly valued compared with the broad market. Growth stocks, by definition, are those anticipated to grow more quickly than the overall market. Their appeal is in their potential. But the more that their share prices rise, the less probable that they can justify those higher prices. A small handful of these “low-quality growth” companies may become the Next Big Thing. But many more may fade into obscurity, as occurred after the dot-com bubble. Continue Reading…