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Writer's pictureInspire Wealth Partners

Are Stocks In A Bubble?

The bubble alarms are beginning to sound louder.


Can you hear them?


In reality, we've been hearing alarms and claims the stock market (in the US at least) has reached bubble territory for the better part of the past decade and could now be due for a meaningful correction.


Economists and market pundits are notorious for attempting to "call the top." Hundreds of "bubble territory" headlines have appeared throughout mainstream financial media throughout the past decade. Here are just a few:

Recently, legendary investor, Jeremy Grantham penned an article titled, Waiting for the Last Dance in which he emphatically warns:


"The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000."


That's quite the claim, but nothing new from investors like Grantham.


The chart below illustrates the underperformance an investor would have experienced had they pulled their money from stocks and invested the proceeds in bonds following "bubble calls" and other ominous comments made by some of Wall Street's most well-known names.


As we've written before, trying to time the market based on prognostication or market commentary is generally a poor idea.


While no one has reliably and consistently been able to spot previous bubbles, let's examine evidence for why or why not we may be in one today.


The Case For a Bubble:


Bubbles are generally defined as short-term periods of exuberance, marked by sharp increases in asset prices, implausible valuations, public excitement usually stoked by the media, and speculative frenzy.


There's no denying speculative frenzy has become increasingly prevalent. Here are a few recent examples:

  • Carole Baskin, an infamous star in the Netflix documentary, Tiger King, was paid $299 to mention penny stock, Zomedica in a video a couple weeks ago. In the week following her video, Zomedia was up 230% and more than 1 billion shares had been traded.

  • Nikola Corporation, an aspiring hydrogen-fueled auto manufacturer went public last year and saw its stock price soar over 800% within a few months. At its peak price, Nikola was valued at nearly $35 billion. However, the company had no revenue and didn't even expect to have a fully-operating assembly plant until 2028.

  • Since its low stock price last March, Tesla's share price has increased eightfold. Tesla is now valued at $1.4M per car based on the company's annual production rate. In comparison, Toyota is valued at $19k per car. If Tesla stock were to continue appreciating at this rate, the company would be worth $51 trillion by the end of 2022. In comparison, the largest stock by market cap today is valued at $2.4 trillion (Apple).

Justifying the valuations for these companies likely requires improbable forward-looking assumptions and draws resemblance to other periods of extreme optimism, notably the late '90s.


Extreme performance can last for years, but it doesn't persist indefinitely.


We've also seen sharp increases in asset prices. In 2020, 150 small, mid, and large cap US stocks at least tripled in market value. Over the past decade, there's only been one year where we've seen 50 of those stocks triple.


As it stands today, US markets are now 35% more expensive (as measured by price-to-book) than they were prior to the Great Financial Crisis in 2008.


Why does that matter?


A higher-priced asset will almost always produce a lower return than a lower-priced asset will over the long term. Expensive stocks today likely means lower expected returns in the future, which could manifest through a market correction or years of lower-than-average returns.


You can't have your cake and eat it too. You can enjoy it now and in the near term, but not in perpetuity.


Bubbles are driven by human sentiment and behavior, making it impossible to predict when they'll burst.


The Case Against a Bubble


Historically low interest rates and accommodative fiscal and monetary policies are primary reasons why current market prices could be justified.


Record low interest rates have enabled companies to increase profitability now and in the future. Low rates have also increased consumer discretionary income by reducing mortgage and other debt interest payments. In addition, low rates decrease the attractiveness of bonds relative to stocks, enticing more investors to buy risk assets, causing stock prices to increase.


Central banks have also intervened in unprecedented ways, injecting trillions into the global economy through lending programs and asset purchases.


Outside of the US, International and Emerging Market stocks haven't had a great run the past decade, resulting in much fairer valuations. In fact, those stocks are trading at near historic-level discounts to their US counterparts.


Within the US, sectors like energy, travel, and financials have turned in poor performance over at least the past 12 months, leaving them far from bubble territory by any metric.


The market is likely pricing in hope for mass vaccine distribution, strong corporate profits, continued government stimulus and central bank intervention, and ultra-low interest rates for the foreseeable future. Assuming these factors play out as many investors expect them to, stock market prices may be reasonably justified.


Conclusion


So, are we in a bubble?


The answer is, "who knows," but probably depends on which part of the market you're talking about.


Certain areas of the US market appear "frothy" and investors are displaying similar behavior as they did during previous periods of extreme optimism. However, that shouldn't be seen as an indictment on the entire global stock market.


Whether or not areas of the stock market are in a bubble, it's always important to invest based on your own risk appetite and time horizon. Diversifying your portfolio across global asset classes should always be an important consideration in the construction of your portfolio, now perhaps more than ever.


 

*Total return through January 22, 2021 of the SPDR S&P 500 ETF.

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