Global equity markets’ remarkable run stretching from last year is raising several concerns about its sustainability and the potential formation of a market bubble. How long till the levee breaks?
Global equity markets have been on a remarkable run recently with key indices setting record highs and attracting significant investor attention amid anticipated policy rate cuts from almost all the world’s major central banks. Many of these banks, such as the European Central Bank, the Swiss National Bank and the Swedish Riksbank, among others, have already started their easing cycles after hiking policy rates to levels not seen for several decades to tame a runaway inflation spike following the COVID crisis. But with the good comes the flip side.
Sky-high valuations and unending investor optimism about emerging technologies like AI, which have fuelled this rapid ascent, has raised several concerns about the sustainability of such growth and the potential formation of a market bubble.
Image: Performance of the ‘Big 4’ stock markets; Source: The Economist
The S&P 500
The S&P 500, a benchmark index representing the largest 500 publicly traded companies in the United States, has experienced an extraordinary rise in recent times. As of mid-2024, the S&P 500 has jumped over 70% since its trough in 2022, and it has risen during 28 of the past 37 weeks, marking its best streak in over three decades, according to numbers crunched by the Economist. The benchmark U.S. index, already up about 16% for the year currently, is only building on its near-22% performance from last year.
This remarkable performance can be attributed to a combination of strong corporate earnings, a resilient U.S. economy, investor optimism driven by advancements in technology and innovation and the looming tailwind of the world’s largest central bank, the Federal Reserve, possibly reducing interest rates from its several-year high of 5.50% this year. However, the rapid rise in stock prices has led to elevated valuations, with the cyclically adjusted price-earnings (CAPE) ratio reaching 36, a level only seen during the dotcom bubble and the 2021 market highs.
The EURO STOXX
The EURO STOXX, an index representing 50 of the largest and most liquid stocks in the Eurozone, has also witnessed significant gains. In 2024, the EURO STOXX is up about 8%, already closing in on its 2023 performance of about 12%. The European market’s rally has been fuelled by robust corporate earnings, improved economic conditions, and investor confidence in the European Central Bank’s monetary policies.
Despite these gains, the high valuations in the European market also pose risks. While not as extreme as those in the U.S., the price-to-earnings (P/E) ratios in Europe have reached levels that suggest the market may be overbought. Investors are increasingly wary of potential economic shocks, such as geopolitical tensions or unexpected changes in monetary policy, which could trigger a market correction in Europe.
The BSE SENSEX
India’s BSE SENSEX, representing 30 of the largest companies listed on the Bombay Stock Exchange, has been one of the standout performers among global indices in recent times. The SENSEX is up about 12% so far this year, building on the 18% gain in 2023 and the 5% rise in 2022. This upward trajectory is driven by strong economic growth, robust corporate earnings, and increased foreign investment.
Despite increasingly being considered a relatively safer option among the riskier emerging-market indices, the Indian stock market is not without its risks. Valuations in India have reached unprecedented levels, with the P/E ratio of the SENSEX at an all-time high. The Indian economy’s dependence on foreign capital flows makes it particularly vulnerable to external shocks, such as changes in global interest rates or geopolitical events. A sudden reversal of investor sentiment could lead to significant capital outflows and a sharp market correction.
The TOPIX
Japan’s TOPIX, which includes all companies listed on the Tokyo Stock Exchange’s First Section, has experienced an unprecedented rally. The index is up the highest among developed market equity markets – about an alarming 21% so far this year, even as Japan’s currency, the yen, is reeling near 40-year lows against the U.S. dollar. This performance is partly attributed to improvements in corporate governance, increased shareholder returns, and economic reforms aimed at boosting growth and productivity.
Despite these positive developments, the Japanese market faces challenges. Valuations, while not as extreme as in the U.S. or India, are still elevated compared to historical averages. Additionally, Japan’s aging population and low inflation pose long-term economic challenges that could impact corporate earnings and market performance. To add to this, the Bank of Japan, the country’s central bank, which despite abandoning negative interest-rate territory a few months ago, has been unable to build on it with additional hikes – which may be the only good way for the world’s fourth largest economy to escape the low productivity-faux liquidity trap it has found itself in for the past several years.
The Curious Case of the Chinese
In contrast to the impressive performance of other major indices, the Chinese stock market has struggled. Since the beginning of 2023, Chinese stocks have been in a slump, with the market yet to recover from a significant plunge. This underperformance can be attributed to a combination of factors, including regulatory crackdowns on key sectors, slowing economic growth, and geopolitical tensions. The Shanghai Composite Index, which tracks the performance of companies listed on the Shanghai Stock Exchange, recorded a loss of 5% last year. It has so far not come close to recouping the losses, trading flat for the year.
The weak performance of the Chinese stock market has implications for global investors. China’s significant role in the global economy means that its stock market woes can affect investor sentiment and capital flows worldwide. Additionally, the divergence in performance between China and other major markets highlights the risks of relying on a single country or region for investment returns.
So…bubble or not?
The rapid rise in global equity markets has raised concerns about the formation of a market bubble. As highlighted in a recent article by The Economist, several factors contribute to these fears. First, valuations in many markets have reached alarming levels, with P/E ratios significantly higher than historical averages. This suggests that stock prices may be overextended and vulnerable to a correction.
Second, there are concerns about external shocks that could disrupt the financial system. Geopolitical events, such as a potential conflict in the Middle East or a Chinese blockade of Taiwan, could trigger market volatility and lead to significant losses. Additionally, economic shocks, such as a sudden increase in interest rates or a slowdown in economic growth, could undermine investor confidence and prompt a market sell-off.
Third, the behaviour of investors themselves poses a risk. The current market rally has been driven by a combination of optimism and speculative behaviour, with many investors betting on continued gains without considering the underlying risks. As noted by analysts from Goldman Sachs and JPMorgan Chase, this exuberance could lead to a sharp correction if investor sentiment shifts.