In a clear market bubble, where can fundamentally-focused investors turn?

The S&P 500 finished 2020 up 18.4%. Whether this price appreciation has more to do with strong fundamentals or with abundant money creation is debatable. Both forces are at work. Central banks responded to COVID-induced financial instability by purchasing bonds, both safe and speculative. Junk-rated bonds have been some of the greatest beneficiaries. The interest rate premium paid for risky debt is currently at an all-time low. The assets of the U.S. Federal Reserve’s balance sheet are currently $7.3 trillion, up $3.2 trillion since early 2020. This activity suppresses yields on bonds and supports higher stock values.

The U.S. dollar was strong in late February and early March, living up to its reputation as a safe-haven when panicked investors fled risky assets. However, since that time it has steadily melted down against foreign currencies and hard assets alike. It is down 5% compared to the British pound and Japanese Yen over the past twelve months and down 10% against the Euro. In dollar terms, most listed commodity prices have appreciated by double digits over the past year. Gold increased 25% in 2020, following a 19% rise in 2019.

Rising commodity input costs and a declining dollar should pressure interest rates upward. The 10-year Treasury now yields just over 1.1%, low by historical standards but up sharply from 0.9% just one month ago. One can’t help but wonder where yields would be if not for central bank bond-buying? As the Fed looks ahead and attempts to taper its balance sheet, the bond market could get very interesting.

One early beneficiary of lower interest rates and higher bank balances has been housing. The Case-Shiller Home Price Index measured 8% year-over-year appreciation as of October. Rising home prices make homeowners richer, adding further to consumers’ fortress balance sheets. Commercial real estate is not nearly as robust. According to FinViz.com, among 21 U.S. residential apartment real estate investment trusts (REITs), the median 1-year return is -10%. Among 27 REITs that own office buildings, the median 1-year return is -27%. This weakness could start to affect the residential market as condominium conversions and other redevelopment opportunities add to housing supply. Combined with upward pressure on interest rates, we would expect the housing market’s rapid growth to moderate as the overall economy normalizes.

Outside of imperiled commercial real estate, almost no asset class looks cheap right now. Bonds certainly do not impress, with safe yields still near zero while inflation knocks on the door. Equities look better. The Wall Street Journal estimates the S&P 500’s forward P/E ratio at 25, almost exactly where it stood one year ago at this time. Investors will need to be selective. Corners of the market are clearly in bubble territory. This doesn’t have to end badly for earnest investors as the 2000-01 “tech wreck” left many stocks unscathed even as speculative stocks fell sharply.

Investors who stick to reliable companies backed by solid fundamentals still have a good chance to grow their purchasing power over time, even in an elevated market. Investors who throw their money into the wind will lose it. It is as simple as that.

Reprinted from the February 2021 issue of the Investor Advisory Service. For more information, to download a sample issue, or to subscribe to the best investing newsletter in the U.S., visit Investor Advisory Service.