Meb Faber, co-founder of and chief investment officer at Cambria Investment Management, knows a thing or two about reading the markets. Before establishing Cambria Investment Management, Faber co-founded AlphaClone and, throughout years of analysis and research, has come to develop a good nose for a market bubble.
Faber says his common sense understanding of bubbles is that they are rare. He pointed to renowned economist Robert Shiller’s definition in which “there's really no possible way you could justify a positive return on the investment in the future”.
Also, importantly, Faber said market bubbles need to have a good narrative, where “people who traditionally don’t invest are getting sucked into the speculative frenzy”.
But there are other ways to recognise the hallmarks.
“People who traditionally don’t invest are getting sucked into the speculative frenzy”
“The nice thing about bubbles, particularly with most capital markets like stocks, is you can use fundamentals as a waypoint or an anchor. A good example, we love to talk about valuations with the US stock market,” Faber told Opto.
“My favourite metric is the 10-year price to earnings ratio,” Faber said. The metric has a history going back more than a century. Faber said that since the late 1980s it has averaged in the low 20s.
“For comparison … we went and created the 10-year PE ratio for every country in the world”, Faber recalled. “We’ve certainly seen what I would classify as bubbles, which would be probably a PE ratio over 40, which traditionally has had negative future returns,” he explained.
However, this can go much higher. Faber recalled a point in 1995 when that ratio hit 80. “To me, that's a real bubble, whereas the US right now, it's low 30s.”
“My favourite metric is the 10-year price to earnings ratio”
Faber acknowledged that valuation as a metric is “a blunt one”. However, he considered that different metrics are all pointing to the fact that stocks are expensive.
“I don't think it's a bubble yet. It doesn't have to get to a bubble. It certainly could go even more than a bubble. But, but what we would say is that future returns … should be muted for the next five to 10 years,” Faber stated.
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