Carl Sagan recommends we see our intellectual adversaries as “kindred spirits in a common quest.” We are all exploring a world that none of us understand. 

As unequivocal bulls for the past year, we have been looking for alternate viewpoints as a counterblast to our optimism. Our search for an articulate bear thesis, however, remains elusive.

This is unsettling. Without the discomfort that comes from contradictory evidence and opinions, we risk becoming complacent. So we ask: Are we in a bubble? Why are bears so bothered? 

Here we examine flows, valuations, earnings, and interest rates. 


Of the $4.6 trillion deployed into mutual fund and ETFs over the past decade, 57 percent went into global bonds and 43 percent went into money markets, according to data compiled by Goldman Sachs. Despite the long-running bull market, cumulative fund flows into global equities were flat. This is starting to change with record weekly equity inflows.

While US equity ETFs picked up nearly $130 billion in 2020, outflows from equity mutual funds amounted to $250 billion. Investors rebalanced away from stocks and toward bonds in record numbers. The behemoth SPDR S&P 500 ETF (SPY) has seen nearly $20 billion in outflows this year.

If capital flows into US stocks are any indication, we are not in a bubble. 

Source: Goldman Sachs

Margin debt is a useful measure of speculative stock market activity, and although it is at all-time highs, we don’t see it as a concern. It is not the absolute level of margin debt but the 12-month rate of change that matters for assessing risks. 

When it is up more than 60 percent over 12 months, prepare for a market peak: margin borrowing was at nearly 80 percent in February 2000 and at 63 percent in May 2007. 

Margin debt at US brokers jumped to $799 billion in January from $562 billion a year earlier, according to data provided by Finra. That’s a jump of 42 percent. Investors are not yet “all in,” betting that stocks can only go up.


To a significant extent, valuation considerations are a poor timing tool and only matter once the economic expansion looks exhausted. This is not the case today. Given the extraordinary fiscal and monetary tailwinds, it remains early in the economic cycle to worry about valuations. 

The S&P 500 trades at a forward price-to-earnings multiple of 22.5, still below the all-time high of 25.7 times the index traded at during the dotcom bubble. The S&P 500 Technology sector peaked at a record 48.3 times projected earnings in March 2000. It is at 25.2 today. History suggests that valuations can go higher yet.

We never imagined the absurdity of negative yielding bonds—some $18 trillion worth, representing nearly a third of all global investment-grade fixed-income assets. Which makes us wonder: what if stocks reach nonsensical valuations?

The free cash flow yield for the S&P 500 index is 3.25 percent (black line, below chart), well above the level that preceded the 2000 and 2007 market tops. Can this fall to zero? What would count as absurd?

Source: Bloomberg

Interest Rates

Of course, the concern is that the stimulus sparks inflation, which hurts stocks. The sustainability of valuations is likely tied to the low-inflation environment. But the truth is more complicated than this simple assertion.

First, the 10-year breakeven inflation rate, or where bond investors anticipate consumer prices will be over the next decade, has struggled to sustainably push past 2.6 percent for twenty-five years. For context, this period comprised the dotcom, housing and commodities bubble, both bull and bear cycles in the dollar, and a five-decade-low unemployment rate. Let’s not forget this. 

While the 10-year breakeven rate has surged to 2.3 percent (since touching 0.47 percent a year ago), we don’t see signs of inflation expectations breaking above their historic range.

Second, an unexpected change in inflation matters in so much as it leads to unexpected changes in interest rates. If the Fed stays on hold and lets inflation run beyond the 2 percent sweet spot (which is the current policy prescription), the decline in the real rate, or the inflation-adjusted yield, will actually continue to support stocks.

Third, research finds that higher inflation and interest rates are positively related to earnings growth. That’s because what underpins them all is a vastly improved economic outlook. For at least the first two years, the effect on earnings is large enough to compensate for the discount rate change. 

Rising interest rates should not pose a threat to stocks until the gap with earnings yields gradually draws to a close, which would reflect excessive optimism about the long-term earnings outlook and complacency about the economy’s ability to withstand higher interest rates.

A closing of the valuation gap would likely result from an extended period of rising bond yields (lower bond prices) and falling earnings yields (higher stock prices). The current 270 basis points spread suggests interest rates can go quite a bit higher than what investors expect before stocks feel the pinch.

The key insight is that inflation and interest rate sensitivity for stocks is modest at this point. We needn’t worry even if the 10-year Treasury yield pushes above 2 percent. The balance of valuation support and earnings growth supports higher stock prices. 



Valuation expansion explains the strong rebound in stocks from the March 2020 lows. The S&P 500 forward price-to-earnings multiple jumped from 14 times to 23 times, or 64 percent, offsetting the steep decline in earnings. “Multiples have peaked for the time being,” we wrote in September. “In 2021, we expect nearly all of the price gain will come from earnings growth.” 

While multiples have cooled off, a robust profits recovery has helped propel stocks higher year-to-date. The S&P 500 is up 7 percent. Strategists see EPS for the index coming in 25 percent higher this year at $175 and gaining 14 percent in 2022 to $200. President Biden’s tax plan, if enacted, may reduce S&P 500 earnings by up to 9 percent—not enough to derail the bull run.

Even under a scenario where valuations fall by 30 percent, there’s enough earnings cushion over the next two years for the S&P 500 to at least remain flat. That’s an attractive risk profile. Why bother being bearish? 

We are emerging from a recession with $2.5 trillion in excess savings on consumer balance sheets. This has never happened before. To what extent can earnings surprise to the upside? The US is growing 7 percent in 2021, its fastest rate since 1984. Operating leverage will kick in as the economy reopens. 

What about the risk that higher wages and taxes may challenge profit margins? Our take is that an increase in unit labor costs would not occur in a vacuum but coincide with better consumption growth and an improvement in selling prices. The implication is that cost-push pressures may not be large enough to undermine profit levels. 

A 2014 IMF study on “Redistribution, Inequality, and Growth” found that fiscal redistribution was generally benign, and the associated narrowing of inequality supported faster and more durable growth.

President Biden’s $1.9 trillion stimulus package, the American Rescue Plan, is expected to reduce overall poverty by more than a third and child poverty by more than half. According to New York Times columnist Jamelle Bouie, the bill is “the single most important piece of anti-poverty legislation” since Lyndon B. Johnson’s Great Society programs.

A late-stage bubble is yet to form. We will be watching for an influx of capital flows and swiftly expanding multiples without a concomitant increase in earnings to warn us of bubble-like conditions.

Photo: Josh Lewis (Dribbble)