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Is this stock market a "bubble"?

Market bubbles have certain characteristics:  They start when there is a rational rise in the price of an asset but that rise in price takes on a life of its own becoming a surge in prices. “Buyers” are attracted to the asset because they have heard extraordinary stories of growth, see the price rising rapidly, and project it will continue.  Throwing caution to the wind, they jump in for fear of missing out. At this point, the price of this asset is no longer attached to the underlying fundamental value – it’s a bubble.

Anecdotal evidence is usually (if not always) a clear indication of a bubble.  People who wouldn’t normally take speculative risk or shouldn’t, sense that it is a “sure thing”.  It becomes a common topic amongst people who wouldn’t normally give much thought to the investment markets.

Mike Kaiser, CFA recalls clear evidence of his experience of anecdotal evidence:

“In the fall of 2000, while watching my 8 year old daughter’s soccer game, I overheard a conversation that caught my ear; a group of soccer moms talking about investing. One of the moms was teaching the others how to day trade tech stocks. That was the peak of the tech bubble.”

Again in the spring 2007, I was driving with my daughter and we passed a new housing development. She asked me how much one of the houses would cost. I replied near $1mm dollars. She asked if there were that many people who could afford a million dollar house and I half laughed and said no. That was nearing the peak of the real estate bubble.”

In this market, we are not hearing anyone say they want to invest in stocks because their prices are “going up”.  In fact, to the contrary, we are hearing many say they want to avoid the stock market because prices have risen for too long and are due to fall. This aspect of caution is not typical of a bubble.

Bubbles have appeared throughout history, going back the first publicly traded company, the Dutch East India Company in 1602. Investors were encouraged to buy stocks in companies that promised tremendous growth from revolutionary developments such as canals in the 18th century, railroads in the 19th and automobiles in the 20th. The enthusiasm pushes prices up which then take on a life of their own and become steeper, creating the “mania” phase of a bubble.

Regulations and the widespread availability of information in today’s marketplace make us less likely to experience a significant bubble with any one particular company. We are more likely to see excess enthusiasm in a sector or area of the economy that heats up (such as recently with technology and real estate).

In the recent real estate “bust”, borrowing was attractive and easy. Too attractive and easy.  Today, we have tightened regulations and scrutiny on lenders and borrowers in an effort to prevent the “boom – bust” experience from 2008.  So hopefully we won’t experience the same dramatic rise and fall of prices as before.  However, real estate is still vulnerable to a bubble because of our low interest rate environment. In fact, we are seeing areas of real estate where pricing seems to be getting “frothy”.

“History doesn’t repeat itself, but it often rhymes” – Mark Twain

Stock prices appear to be on the high side when you compare them to historical valuations.  But this can be explained:  (1) inflation and interest rates are very low by historical standards and (2) technological advances.

Over the past 70+ years, the average return of a 10-year Treasury has been around 6% but today we know that if you purchase a 10-year Treasury you will only get 2.4% (11/20/2017).*  This is much lower than what was achieved in the past and is a consequence of low inflation.  The average return for stocks over that same 70+ year period was around 12%.*  It makes sense, just like the Treasury, that we should adjust expectations to a lower return from stocks. Perhaps around 7.5%.

Higher stock prices are likely a consequence of being recalibrated to lower inflation and low interest rates.  Not from chasing prices as you see in a bubble. Unfortunately, predictions on inflation are very hard to make and it could remain low for a long time.

The higher stock prices also don’t appear to be a consequence of speculators or unwarranted enthusiasm.  Advancements in technology are enhancing profitability. Not only for the companies creating it, but for those who are using it.  Companies in every sector have benefitted from lower production costs and lower delivery costs to consumers.  Lower costs allows for higher earnings. This positive impact on the market is the new reality which helps explain the heightened valuations.

“Even if it isn’t a bubble, what about it being expensive?”

Stock prices are high compared to averages of historical fundamentals. If you are a short term “trader”, we might be due for a correction of some sort, especially if the treasury yield continues to flatten, which could create some friction for borrowing. If you are a long term “investor”, trying to predict when to buy and when to sell is likely to do you more harm than good.

*Source: Average 1 year returns from January 1950 through September 2017
Standard & Poor’s Corporation; Ryan Labs, Inc,: Merrill Lynch, Pierce, Fenner & Smith: Bureau of Labor Statistics