Components of the market are in a bubble, however they pose little danger to the S&P 500, Goldman says

People walk past the New York Stock Exchange (NYSE) in Lower Manhattan on October 2, 2020 in New York City.

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Parts of the market are in bubbles, but they are unlikely to bring the overall market with them if they burst, according to Goldman Sachs.

The Wall Street company said the exuberance of acquisition companies for special purposes, as well as investor interest in companies with negative returns, is a cause for concern. However, these speculative areas do not pose any risk to the overall level of the S&P 500.

“Pockets of the market have recently shown investor behavior consistent with bubble sentiment,” Goldman Sachs chief US equity strategist David Kostin told clients. “However, due to their small share of market capitalization, these excesses represent a low systemic risk for the broader market.”

Fifty-six SPAC IPOs completed in 2021, raising $ 16 billion, according to Goldman. This is on top of the 229 US SPACs that raised $ 76 billion in 2020 in what has been referred to as the “Years of the SPAC,” Goldman said.

“Low interest rates, the flexible structure and the two-year window to find a target before capital is returned suggest that the popularity of SPACs will last in the short term. Importantly, we should see little risk to public equity markets investor enthusiasm for SPACs is waning, “said Kostin.

It has been a mania in SPACs as companies shy away from the traditional IPO plagued by the coronavirus pandemic and wild volatility. A SPAC is a blank check company established to raise funds to finance a merger or acquisition within a specified period of time. The target company will be listed on the stock exchange through the acquisition.

Shadow of 2000

There is also bubble-like behavior in stocks with negative earnings and strong outperformance recently, Goldman said. Over the past 12 months, stocks with negative earnings have outperformed the average stock by 40%, a 97th percentile ranking. Goldman also said the trading volume of these negative earnings stocks is at a historic extreme.

“These companies account for 16% of equity trading, exceeding 15% in 2000. While this increase does not seem sustainable, it also appears to pose little risk to the broader market as these companies account for only 5% of total market capitalization. “said Kostin.

But Kostin sees reasons not to worry about the overall market. One of the bigger bulls on Wall Street, it rallied 11% in the S&P 500 to 4,300 at year-end.

The stock valuations are absolutely extremely high, he noted. However, taking into account the low interest rate environment, the S&P 500 is trading below its average historical rating. Investors see low interest rates as a kind of valuation cushion.

Even the economist Robert Shiller, who created the cyclically adjusted price / earnings ratio, or the CAPE index, pointed out that the index shows that stock valuations “aren’t as absurd as some people think,” assuming that they are Interest rates remain relatively low, Goldman noted.

Also, the current market lacks the extreme investor leverage that is common in stock bubbles, Goldman told clients. Thanks to unprecedented fiscal stimulus, consumers are cash rich and the disposable income of US households soared in 2020. These excessive savings pushed the debt service ratio to its lowest level in 40 years, so the strong capital inflows were funded by cash rather than leverage.

Beware these companies

One part of the market that appears frothy and could pose risk to the broader market is extremely high growth, high multiples stocks, according to Goldman.

“As with bad earners and penny stocks, the trading volume and stock prices of stocks with an EV / sales multiplier have increased over 20x,” said Kostin. “However, these companies are much larger, together accounting for 23% of trading volume last month (96th percentile since 1985) and 9% of market capitalization.”

Companies with this high growth ratio (enterprise value to revenue) accounted for 2% of trade in 2019, but rose to 10% in August 2020 as interest rates fell.

“History shows that when investors buy the highest-rated companies, there is a good chance they will outperform,” said Kostin.

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– with reports from Michael Bloom of CNBC.

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