How Bubbles Form

If we assume that this stable financial atmosphere (very slow growth, low inflation, zero interest rates, high profit margins)  continues indefinitely and the fear stimulus of the ’08 meltdown fades, then the human condition says we can pay very high prices for stocks.

Let’s look at one stock that represents the market as a whole for an example.  YUM! Brands has a stable and growing business.  The stock currently trades at $73.86.  I will use this stock to compare the two fundamental choices an investor has.  An investor’s basic choice is to invest in either a 1o year US Treasury bond (T-bond) paying 2.69% or buy into equity investments.  YUM! pays a dividend of 2% ($1.48 annually ) that has been growing about 10% a year. At first, it looks like the 10 year T-bond is a better deal, i.e. 2.69% vs. 2%. Yet, if YUM!’s dividend continues to grow at 10% then 10 years from now the dividend will be $3.84 and your yield will be 5.2%.  So the choices are not completely clear because YUM!’s dividend is growing and the T-bond’s return isn’t.

The dividend discount model provides an answer.  The value of YUM! according to the formula is:

Price = D/(k-g)  where D = the dividend, k is the discount rate in %, and g is the very long term growth rate in %.

k is an estimation of how risky YUM! is relative to the T-bond.  This is where the troubles start. Coming out of 2008, investors thought that stocks were way more risky than the T-bonds and the growth rate, g, was going to be low because the economy is going south.   So at that time an investor might have used a k of 10.76% (4x as risky as a T-Bond) and YUM! can grow at 2% for a very long time. So YUM! would have been valued at :

$1.48/(.10-.02) or $18.50 per share (actual low price in ’08 was $21.50)

As the financial world became more stable investors may have thought that YUM is only 3X as risky as the T-bond (k= 8.07%) and that YUM! can grow at 3% for a very long time. We would calculate:

$1.48/(.0807-.03) or $29.19 per share

Today,  the situation looks very stable and things will continue like this indefinitely.  So now investors may perceive YUM! as only 2x as risky as a T-Bond (k=5.38%) and YUM! can now grow at 4% for a very long time.  YUM! has been growing north of 10% for many years on average so 4% for a very long time now seems rational.

$1.48/(.0538-.04) =  $107 per share

We could keep going here and come up with some really high numbers for YUM!.

The chart below shows what is happening in the overall stock market. The numbered lines show the premium investors are willing to pay for the market.  The market price is the squiggly line.   The growth rate of the economy has not changed for several years, either has interest rates.  Thus the main reason the stock market has been going up and may well continue is that the perceived risk or k has been dropping.  Investor are willing to pay higher and higher prices just because they think the risk has declined not because the economy or the growth rate has improved.   Noticed how investors believed there was very low risk just before 2008.  Just because investors think the risk is low doesn’t mean it’s so, it just reminds us that investors measure the current state of affairs without regard to what could happen. History has shown financial shocks are not predictable and are more likely than can be calculated.

As long as there are no financial shocks, stock prices are going to continue higher and in my estimation have become at risk for financial shocks.  There is no margin of safety between peoples’ perception of low risk and the reality that risk exists in the same probability as it always does.  Just because something hasn’t happened recently doesn’t make risk go away.