Recently, an increasing number of pundits (and a smaller number of actual stock market analysts) have begun using the word, “bubble,” to describe the U.S. stock market. That chatter has picked up even more lately, when Donald Trump began saying that the stock market is a bubble propped up by the Federal Reserve keeping interest rates low. But, is the stock market really in a bubble? What is a stock market bubble, anyway? How can you tell if there is a stock market bubble?
What Is a Stock Market Bubble Really?
Let’s start with the fact that you should NEVER listen to a politician (including candidates) when they talk about the stock market or the economy. They are always campaigning, even in off years, and getting people to think the right thing outweighs any allegiance to the truth. In the case of Donald Trump, he is campaigning on the economy being bad, but a rising stock market is shooting holes in that claim. By saying it’s a bubble, he’s trying to imply that it isn’t a REAL sign of economic growth, and that the economy actually is bad.
But, beyond politicians, how can we tell if a bubble is real?
For starters, it is important to understand that unlike, say a recession, there is no accepted statistical, or mathematical, definition of a bubble. So, there is no way to officially call a bubble when one occurs.
That being said, we can look at previous bubbles and compare them to the situation now, and get a good feel for whether we are truly in a bubble.
First, of all, in order for a bubble to exist, the investments in question must be “over-priced.” If prices are justifiably rising, then there is no bubble, that is just the market doing its job by properly pricing assets that are increasing value.
So, is the stock market over-valued? Some analysts and financial writers point to the increasing Price to Earning ratio of the market as a whole. There is even a special PE ratio called the Shiller PE, that some people like to point out “called” some of the previous stock market bubbles. If there is a valid argument for the stock market being in a bubble, it is that PE ratios are historically high.
However, there is a catch to PE ratios. While falling stock prices can bring PE levels back in line, so can rising earnings. Remember, the ratio is Price to Earnings. So, increasing earnings would also lower the PE. If you feel that the U.S. economy is poised to finally grow more than the slow smolder that it has been doing for the last few years, then you would believe that those earnings are poised to increase. In other words, if the economy is growing, then the higher PE numbers might be justified.
What Does a Bubble Really Need?
As someone who was around for the Tech Bubble bursting in 2000, and the Real Estate Bubble bursting in 2008, there is one thing that is very, very different about this stock market, and its so-called bubble.
I call it the Everyone Factor. In 1999, everyone, and I almost mean that literally, was in the stock market. Not just 401k plans, and IRAs, but everyone knew someone who was a day trader. And, most people claimed to know someone who had quit their job to become a day trader and made tons of money. Everyone had an eTrade account, or a Fidelity account, or some other online super-discount broker, and they were buying and selling stocks, particularly internet-based stocks. The oft-used cautionary tale of the era is Pets.com, a company that had an IPO with zero profits, and only slightly higher earnings, only to see its stock price go to zero about as fast as humanly possible. By then, almost everyone lost at least something when the bubble burst and took the economy with it.
You see it again in 2006 and 2007. Everyone was investing in real estate. Your average neighborhood had at least one person in it who was doing fix and flips. There were people buying up homes in new developments with no intention of ever living there. I remember a group of coworkers pooling money together to buy houses in Arizona. Lenders were offering zero money down mortgages, and even money back mortgages for people buying their second, or even third house. The people at PIMCO tell the story of an analyst in Las Vegas sitting the back of a cab listening to the taxi driver tell him about the three investment properties he had.
In both of these cases, the bubble was inflated not just by people maybe paying a little too much, but by an ever increasing inflow of new investors, and new investor money, often borrowed money. The bubble wasn’t normal up and down price movements being too optimistic, but rather entire legions of people who had never invested before, suddenly throwing in every thing they had, and then borrowing money to invest even more.
This Everyone Factor is what is missing in this supposed bubble. Ask around your office. You’ll be lucky to find two or three people who are invested in stock market beyond their retirement accounts, or maybe a few shares in Apple. No one is a day trader anymore. No one is mortgaging their house to buy stocks. In fact, a great deal of the daily price movements in stocks is institutional computer trading, not the average Main Street investor bidding up stocks.
All of this begs the question. Can a stock market bubble occur if no one is in it?
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Obviously, the market will go down again, but 2016 alone has thrown out some corrections, and sideways movement to limit the speed of the stock market rise, and nothing has “burst.”
The Fed and the Stock Market Bubble
There are those that believe the low interest rates the Fed has set is the cause of the stock market bubble, and consequently, increasing them would be the cause of the bubble bursting.
On the one hand, this makes sense. Rising interest rates were the likely cause of the real estate bubble finally bursting. However, without the Everyone Factor, in what way are the low interest rates actually inflating the market?
If the low rates are boosting the markets, because companies are taking advantage of them to increase earnings and profits, and investors are noticing, then that is exactly what you want to have happen. That’s just good business. That would be the E increasing to lower the PE ratios.
In order to low rates to be artificially inflating a bubble, investors would have to be using borrowed money (or money derived thereof) to be purchasing stocks. There is little evidence that is actually happening. In other words, it seems like the Fed’s low rates are boosting the economy (which they are supposed to do), which in turn is boosting the future prospects of U.S. companies, which then, rightly, is boosting the stock prices of those companies. That logic would mean the U.S. economy itself is in a bubble, but there is literally no one saying that.
In the end, this market run has gone on a long time, which is where this bubble talk is coming from. We know the market doesn’t go up forever, and some analysts think this one has gone up too much, for too long. But, that does not a bubble make.
A correction is coming someday, most likely in response to some non-Fed event like another China financial issue, or even the economy tipping back over into recession. Guessing when that day happens is tricky. Even the Shiller PE that people are pointing to was three years too early for the Internet Bubble top.
Either way, chances are good that you’ll see a normal downward stock chart that bottoms out when the external issue causing it goes away. For now, the market should head back up afterwards so long as the economy keeps adding jobs.
So, as always, long-term investors with a diversified portfolio should rebalance when it is appropriate.
For short-term investors, it is important to keep your investments in strong companies with either some downside protection in the form of options, or stops that get you out. But, even if you choose to go without protection, chances are, you’ll see a normal downturn, not a bubble-popping crash.
This article is for informational purposes only and is not a recommendation to buy, sell, or hold stocks. Consult your financial professional for advice specific to your own finances and investments.