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‘Confusing Time’ for Managers Weighing Stock Bubble, Page Says

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(Bloomberg) — A stellar year for the stock market is coming to a close and money-managers are looking ahead to what 2022 might have in store. But worries persist, including the perennially nagging question of whether the stock market is overvalued and in a bubble.

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Sébastien Page, head of global multi-asset at T. Rowe Price, joined the “What Goes Up” podcast to talk about his views on that, his team’s current strategy, the need for diversification and his year-ahead outlook. Page manages a set of multi-asset portfolios representing more than $450 billion in assets, including the firm’s target date portfolio franchise.

Below is a lightly edited transcript of the interview highlights. Click here to listen to the full podcast, and subscribe on Apple Podcasts, Spotify or wherever you listen.

Q: I’m curious to hear your view on what we’re heading into next year — how are you taking all the different inputs and seeing how the year ahead might look?

A: A simple question right now that’s on everyone’s mind is: are stocks in a bubble? And it’s really a complicated question. This is going to sound unusual, but I can make the statement that at the same time, stocks are both as expensive as they’ve ever been and as cheap as they’ve ever been. So how do I get to that statement? If I look at the price-earnings ratio on the S&P 500, it’s in the 99th percentile compared to the last 30 years. But if you think stocks are expensive, have you looked at bonds recently? And if you compare the valuation of stocks — that PE ratio, and you can invert it and look at the yield, which makes an easier comparison — with bond yields and in particular real rates — the yield you get on bonds after inflation — then you get to the conclusion that it’s in the bottom 1%. So stocks are as cheap as they’ve ever been.

So it’s a confusing time for asset allocators. We just had a debate between the bulls and the bears in our asset-allocation committee. So as we look into 2022, the bears are arguing that we’ve borrowed from the recovery. In other words, valuations are a sign of that, and monetary and fiscal policy have been so extreme that one of our committee members said, look, every inch of recovery will get taken away by the Fed’s need to taper. And on the fiscal side, we’re at the end of the days of sending checks to people. One reason to worry about asset valuations is that it’s been liquidity driven…

What are the bulls saying in our committee now? They’re saying, look peak growth doesn’t mean low growth. The delta situation, ultimately we hope, will be better in six, nine, 12 months. Think about a back-to-normal world where there’s less Covid, supply chains slowly normalize, services spending increases and so on. So the bulls are saying growth is slowed and delayed, but it’s not derailed. We’re still in a recovery….

The bottom line is that over the next year, we will face declining growth, but still very high growth, declining liquidity, but still very high liquidity, and settle into the mid-cycle game. For that game, you need earnings to sustain stocks more than rising valuations, which is what happened this year…

It’s a massively distorted economy. Ultimately we’re more bearish on bonds than stocks. So where we settle all of this between the bears and the bulls is that we have taken some profits in our portfolios by selling some stocks, but on the margin. We’ve sold about 1% of our stock exposure.

But we’re also long growth, we’re also long the economy. So we’ve added risk back into the portfolio through relative valuation. So to go long the economy, long cyclicality, we have shorted Treasuries, we have added, on the margin, to credit, and we’re long small-cap and value stocks. So we’re adding back cyclicality into the portfolio as we’re selling some stocks on the margin. That’s how we’re thinking about 2022.

Q: You’ve sold 1% of our equity exposure, and you moved some to liquid alternatives — what does that entail?

A: As you sell some stocks, maybe you start taking a bit of profit, you pull back a little bit, you stay diversified, you stay invested, but the question becomes, where do you put the money? And this relates to the 60/40 question. About 12% of our core bonds exposure has been transferred in our flagship global allocation strategy to liquid alternatives. Those are strategies that are active-management focused. So you need skilled active management to succeed here. And they allow for short positions — they’re not linked to the big market trends in either equity returns or interest rates. So that’s how we add some diversification into the portfolio. We’ve also added, on the margin, to loans as an asset class — bank loans tend to do OK when rates rise relative to long Treasuries, for example. And we’ve also added, on the margin, to credit more broadly, high yield in particular. So that’s how we’re positioned from a tactical perspective at the moment.

Q: How do you think about crypto as an asset class?

A: First of all, just look at the size of crypto and it’s hard to disagree with the idea that it is an asset class. Overall, it’s bigger than, say, the high-yield bond market in the U.S. So it is a force to be reckoned with. In most of our portfolios in our business, our clients aren’t giving us the mandates to invest in crypto, but we do research in that space because it’s going to influence how a lot of companies do business in multiple sectors. We have an army of stock analysts at T. Rowe Price and some of them are following the space. We’re looking at it at this point, personally I can say, not from an inflation-hedge perspective simply because it’s just still such a speculative asset class…

Sometimes crypto moves and it’s just hard to actually explain, right? Oh, it’s down 10%, maybe it’s this Tweet, it’s a little bit mysterious, nebulous. This is a sign that it’s still an asset class that moves on sentiment and speculation. Let’s suppose 80% of the volatility of crypto really is speculation, trend-chasing, sentiment. Well, that doesn’t make for a really good inflation hedge, unless maybe you think about it from a very, very long-term perspective. It’s an evolving space, it’s an important space for asset allocators to think about. The fact that it’s highly volatile is not necessarily an issue — it means that it’s more capital efficient, all else being equal. But it’s still, for us, not an inflation hedge.

Q: What might you recommend as an inflation hedge?

A: There’s too much money — demand — chasing too little stuff to buy, especially goods, which creates supply issues. This is not new — everybody’s talking about the mother of all traffic jams. At this point at T. Rowe, we don’t have a house view. So portfolio managers across our investment platform are actually divided on the question as to whether we’ll face runaway inflation. The trick with the transitory question is that everyone has a different definition of transitory. You need to define transitory first and then express your view. So here, I’m going to say, maybe rephrase the question: Are we going to face runaway, out-of-control inflation that will force the Fed’s hand?

I think overall, we’re close to peak inflation, but we won’t settle back down to pre-Covid sub-2% numbers in the foreseeable future. Right now, as we speak, five-year breakeven inflation is trending up. The Fed can be flexible targeting 2% — but there’s flexible, and then there’s, as breakevens are implying, letting inflation average above 3% over the next five years. Something has to give.

How do you hedge those risks? We hold short-term TIPS in the portfolio. But overall expected returns on short-term TIPS are fairly low where we sit now. We also hold a fund of real-asset equities. So these are stocks that are inflation-sensitive — so think about real estate, REITs, metals and mining companies, precious metals, energy companies.

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