Are We In A Bubble?

Are we living 2008 all over again? The Dow is at record highs, consumer debt is at record highs, and the Federal Reserve Chair seems high…. Does all of this equate to life in another bubble that might be about to burst?

First of all, what exactly is a Bubble? Most definitions of a bubble say it is an extreme run-up in the price of an asset or an asset class that is not justified by the fundamental supply and demand factors supporting those assets. In bubbles you’ll see irrational “herd behavior”, and “groupthink” rapidly driving prices higher as investors experience FOMO, which I wrote about here.

bubbles
Are we in one these bubbles? Photo by Catherine Zaidova

Second of all, what does it mean for a bubble to burst? Most pundits will start talking of “bursting” when the prices of a “bubble” fall over 20% and sustain those losses under high-volume “panic selling” in a very short timeframe – especially true on the back side of speculative and rapid run-ups.

This bubble bursting would be different than a “bear market” or a “recession” which might produce a 20% drop, but over a longer period of time. Obviously some bubbles burst dramatically, with rapid drops of 50% to 90% not uncommon after the dust settles.

The Market Today:

There is no denying the stock market right now is en fuego. Since Donald Trump was elected the “Trump Bump” has the market up over 20% and hitting 40 new highs since Election Day. That means we have seen record highs in 1 out of every 5 trading days since Nov. 8!

As I write today both the S&P500 and the NASDAQ are just off their record highs and the DOW is topping 22,000 for the first time ever. We’ve seen almost $4Trillion of wealth created in the stock market since the night Hillary packed away the purple pantsuit.

Are we in a stock market bubble? Is today’s market behavior justified? Let’s take a look and see if we can find an answer that makes sense…

A Few Indicators:

S&P 500 companies are reporting double-digit earnings growth for the first time in over 6 years as our economy enjoys low inflation, low interest rates, low stock market volatility, and ample liquidity (lots of money moving into and out of the market). This is a good sign.

The market’s price-to-earnings ratio, however, is near record highs. The Shiller P/E Ratio which measures the market’s price relative to its earnings is as high as it was in 1929 & 2000 – years where we saw “crashes”, and higher than in 2007 when the housing bubble burst. This is a troubling sign.

However, this price-to-earnings indicator must be viewed against our current economic environment of very low stock market volatility, very low inflation, and record low interest rates. For now, the market seems quite capable of supporting its price-to-earnings metric. This is a good sign.

In the bond market, 10-year T-Bills are yielding 2.3%, which is only 0.4% after accounting for inflation. Compared to a historical average of a 3.5% return after inflation, this is quite low. Remember, as bond yields decrease, their prices increase. Historically, bond prices and stock prices are strongly inversely correlated (moving opposite each other), but these days they are rising and falling together. Currently, bonds are more expensive than stocks in terms of relative value. This is an odd sign.

Consumer financial confidence during all of this is higher than it’s been in over 8 years and people are eagerly looking to invest. Since you can’t make money in savings accounts or CDs anymore due to low interest rates, we’re seeing the prices of stocks, bonds, and real estate continue to rise. Folks are looking to earn money with their money. Like the bond market anomalies above, I see this as a by-product of Quantative Easing and a government interference in the markets that has redirected investor money in a dramatic way. For now, we’ll call consumer confidence a good sign.

On the flip side, vast consumer confidence has run consumer debt to record highs, even higher than 2007. Spurred on by record low interest rates, Americans are loading up the credit cards and fueling the economy with spending. The fact that many cannot afford the stuff they are buying is not stopping them. As interest rates begin to rise and continue upward in the near term, that could start to freeze consumers out of the credit game, thus slowing their spending. Debt is always a troubling sign.

One common indicator of a recession is an “inverted yield curve” where short terms rates begin to increase over the long term rates. Currently, the 10yr bond yield is 2.26% (flat over the past 3 months) which is over 1% above the 1yr bond yield at 1.25% (up .25% over the past 3 months). Though the gap is closing a bit, that 1% delta is a good sign.

Janet Yellen has said she does not see another market crises like 2008 happening in our lifetime; however, she was recently at Harvard University accepting some kind of important award and while talking about the events of 2008 she said; “We really didn’t see that coming.” As the market tops all time highs, I think Janet Yellen might be high herself in making such audacious predictions when her vision is obviously flawed. She is seeking to further raise interest rates AND unload the assets on the Fed’s $4Trillion balance sheet. Where the Fed’s assets go and their effect as they re-enter the market is an unknown. This is uncharted territory with high stakes involved, and I’m not sure she is the best person to deal the cards. This is a troubling sign.

With mortgage rates and unemployment both very low, the Case-Shiller 20-city housing market index has notched its 4th consecutive all-time high in 2017 and is rising at its fastest rate since mid-2014. Sane lending policies have returned and the NINJA Loans (no income, no job, no assets loans) of previous administrations that viewed home buying as an inalienable right are now a thing of the past. Banks are not making as many risky loans to unqualified buyers, meaning foreclosures are the lowest they’ve been since 2005. Home prices are shooting upward. All in all the housing market seems robust and well-supported by the underlying economy. This is a good sign.

Putting It All Together:

There is a lot of data and a lot of noise out there. A lot of noise… Looking at the big picture, I see no reason to think “bubble”, nor do I see any reason to drastically change course. As is usually the case, Bulls can find their reasons to think this party is going to keep on rockin’ and Bears can find the data to indicate we’re all going to be lining up at soup kitchens by the end of the year. The key in any market is to filter out the noise and focus on your strategy, your investment timeline, and your expected results. Your big picture.

Get your investment allocation set with a reasonable mix of stock to bonds. I would suggest somewhere between 70/30 and 80/20 – and then keep going. With this allocation mix, history shows you’ll have the best risk/reward profile in the market. Downturns and bubbles bursting should not affect your investment allocation game plan. Resist the temptation to cash out and sit on the sidelines or to dramatically change your allocation in favor of gold or other “safe havens” based on market fear or scary predictions. If you want to own some gold that is fine, but make it a part of your total allocation strategy and stick to that plan.

I would recommend you continue your investing on a regular basis. I am still buying my stock/bond mix every week. I use auto-drafts from my checking accounts and deductions from my paychecks. I’m investing the same amount per week at the market top as I will be when the market drops. Even dramatic fluctuations should not alter your game plan. I don’t slow down my buying when the market peaks, and I don’t increase it when the market dips. Slow and steady wins the race. That is plan.

What’s Next?

It’s safe to say this stock rally that began on 2009 is “mature”. It’s like running up on that green light that’s been green for a really long time as you approach the intersection at full speed. What should you do – foot on the gas, foot off the gas, or foot on the brake? My foot remains on the gas.

green traffic light
The light is still green… Photo by Carlos Iniguez

Yes, the stock market will drop at some point – where that green light turns yellow. Yes we will soon have a year where our returns will be negative – where that yellow light turns red. In the long run, however, keep your eyes on your destination and not the individual traffic lights – your engine keeps running, right? That engine is your constant saving and investing that will eventually get you where you want to be.

car racing
Let’s go! Photo by Jakub Gorajek

One note on “the noise” – don’t panic when you hear news agencies talking about a 100 or 200-point drop in the Dow like it’s an epic event. Keep your perspective – that’s less than 1%. I always chuckle when I hear the talking heads alarmingly shouting “The Dow tumbled today losing over 200 points in heavy trading.” Yeah, in 1954, that 200 points was a big deal. Today you’d have to see the DOW shed over 5 times that amount in a day in order to become a newsworthy event. Nothing to see here…

Remember…

Money you invest in the stock market should have a timespan of at least 7 years and preferably longer. If you’re going to drop money in the market and panic at a 5% drop that could very well happen before Kim Kardashian bares her ass on the internet again, then invest in a money market account (cash) instead. You’ll sleep much better, but I’m sleeping just fine in this market for now – and I’m making some really nice coin too.

Good night, and God bless!

 

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