Are We in a Bubble?

The latest rage on Wall Street is to pronounce that stocks are in a bubble. This is rather unusual in that true bubbles are very rare. This is, of course, different from stocks dropping in a routine lousy market. That happens every few years.

Do I think that stocks are in a bubble? Honestly, I don’t know. And more importantly, I don’t much care. Let me explain.

For one, it’s odd to make a judgment about the aggregation of 6,000 publicly traded stocks. Our Buy List is pretty well diversified and that’s just 20 stocks. Where the entire S&P 500 is headed isn’t that important for a disciplined stock picker.

Also, even if the market is about to plunge, it’s very difficult to get the timing just right. Lots of people saw the housing bubble but they were very early. The bubble kept on going. Recently I noted that if an investor bought an S&P 500 index fund just prior to the Financial Crisis, say in March 2008, and held on to today, they would have made a decent return by historical standards. Time may not heal investing wounds, but it sure can help a lot.

When looking at valuation metrics, I urge investors to look at as many as they can, but never be a slave to just one. I’m particularly leery of metrics like the Cyclically Adjusted P/E ratio, also known as CAPE. The CAPE looks at the stock market’s current value weighted against the last ten years of earnings. The idea is to smooth out the economic cycles. I think this is a bad idea because stocks and earnings are themselves cyclical.

Also, the inclusion of so much prior data is, in my opinion, an unfair anchor to carry. The historic plunge in corporate earnings in 2008-09 will still be a part of CAPE for another five years. If we look at operating earnings or dividends, we can see what an outlier that profit data is. Interestingly, the market’s dividend yield has remained fairly consistent for the last decade, except for the worse parts of the Financial Crisis.

After two of the biggest bear markets in history is precisely when so many people are scared of another bubble. I’m reminded of people saying that shortly after 9/11 was actually the safest time to fly. Bubbles are now, apparently, everywhere.

I think the best way to look at the issue is to divide bear markets into two categories. One is where price shoots far above value. That’s your classic bubble ala 1987 or 2000. The second is when value crumbles beneath price. That happened in 1990 and 2008.

You might be surprised to hear me say that 2008 wasn’t a bubble. That’s right; stock valuations really weren’t that excessive. It was the fundamentals that turned out to be terrible. Believe it or not, stock valuations were above average in 1929, but not out of sight. The frothiest part of the bull market occurred in the last six months. The 1920s was not a decade of stock euphoria.

I think there’s a natural tendency to reverse engineer a narrative that the world was enthralled to greed and everyone bought stocks without thought. That describes the feeling about Tech stocks in 1999, but it’s not an accurate description of today’s environment. The S&P 500 is going for about 17 times this year’s earnings. That’s about normal. The P/E Ratio has risen over the last two years, but it’s really gone from low to average, not from normal to nose-bleed territory.

Analysts currently estimate that the S&P 500 will earn $120 per share next year. Now’s the time for skepticism. For one, analysts don’t have a great forecasting track record. The critical question is, could fundamentals soon fall apart? Are there hidden factors that might make the S&P 500 earnings, say, $90 or even less next year? This is the question to worry about.

It’s also hard to predict things that are unexpected because, well, they’re not expected. If they were expected, they probably would be much less interesting. Also, it’s the unexpectedness of an event that makes it important.

The things that worry me are the things we aren’t thinking about. For one, corporate profit margins are very high. I think it’s reasonable to expect that earnings growth will be below economic growth over the next several years. Though the high profit margins probably aren’t a reflection of corporate greed, rather they’re a natural byproduct of slow growth and low interest rates.

Earnings recessions generally don’t announce themselves beforehand, but there are some useful warning signs. One good indicator is the yield curve. When short-term rates rise above long-term rates, the economy often runs into trouble soon after. For now, the yield curve is far from inverted.

Another late cycle indicator is rising inflation. According to the latest numbers, that’s not a problem either. I also like to follow the monthly ISM reports. A reading below 45 is often a sign of trouble. Once again, we’re in the safe zone.

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Posted by Eddy Elfenbein on November 11th, 2013 at 10:44 am

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.