3 Reasons to Stop Fearing a Market Bubble

by James Brumley | November 26, 2013 1:07 pm

The recent onset of the bubble discussion is certainly understandable. The market is up 25% with a month to go in 2013, the average stock’s P/E ratio of around 17 feels a little more frothy than the norm, and the S&P 500 has now rallied for more than two years without a “normal” bull market correction of more than 10%.

Generally speaking, that feels an awful lot like things were in the late ’90s, and how things felt in 2006 and 2007 as well.

The devil is in the details, though. While stocks might be due for a dip, a closer look at the current metrics — and the immeasurable nuances — suggests there isn’t a bubble ripe for the popping just yet. The three best non-bubble arguments include:

Current and Projected Valuations Are Below ‘Peak’ Norms

To give credit where it’s due, it was Charles Schwab strategist Liz Ann Sonders that did the legwork to find out that, while pricey, stocks aren’t valued at unheard-of levels[1] on a trailing or a forward-looking basis.

As it stands right now, the S&P 500 is priced at 17.6 times its trailing income. However, the typical bull market “peak” P/E reading (going back more than 60 years) is 18.7. The 2007 peak was a tad lower, at 17.5, so that could ring mental alarm bells. But, it’s not unusual to see the market’s P/E ratio reach the very high teens or the low 20s from time to time.

The forward-looking P/E ratio of 15.9 right now is even more encouraging vs. the normal forward P/E measures seen at bull market peaks. The average projected P/E at market tops is 18.1. The forward-looking ratio when the market peaked in October 2007 was 22.4, and the forward-looking P/E measure when the S&P 500 was topping out March 2000 was a dizzying 27.2.

At this time, earnings still are catching up to the market’s price, while profits typically are stagnant or waning at real market tops.

The Economy Is Mediocre — at Best

You can point to several different clues: low inflation, tepid employment, mediocre GDP growth. They all say the same thing — this isn’t an economy being driven by demand for want-to-have things, but rather, an economy being propped up by have-to-have things. (Apple products have been shoved out of the latter category into the former.)

So how does that make our current situation not bubble-esque?

Because nearly every bubble we’ve seen pop during the modern economic era was popped because the consumption of goods outpaced their production, and that consumption was driven by leverage (credit) in one form or another that surpassed the means to service that debt. Yes, this means stocks as much as it means iPads or cars or houses.

Although sales of everything are still on the mend from the 2008-09 lull, we’re nowhere near as consumption-crazy as we were then … at least not yet. We are pointing in that direction, however. It might be another couple of years before we start to borrow against anything to buy, well, anything else.

The bubble will be marked by demand driving inflation back toward 3% vs. the current annualized inflation rate of less than 1%, which will likely only happen if we can pull the unemployment rate beneath 5%.

That’s when you should start getting worried.

Euphoria Isn’t Rampant

The catalyst for all the bubble talk in November might have been all the talk about retail investors — the ma-and-pa type of people who live next door — finally pouring into the market, not wanting to miss out on any more of the stock market’s apparent easy gains. Since this is the proverbial “dumb money,” the fact that these little guys want in indicates that it’s time for the smart money to get out, which would incite an avalanche of selling pressure on stocks.

But there’s one problem with the notion that Joe Schmo is pouring his life savings into the stock market: It’s just not true.

Oh, there are anecdotal pieces of data that could indirectly imply that small investors are wading back into the market. Most of it centers on stock mutual fund inflows, which admittedly have been strong this year. As of the end of October, a record $231 billion[2] had been poured into the stock market via mutual funds this year.

It’s a bit of a dubious honor, however, as much of that “new” money was merely redirected from the bond market’s normal flow of cash into its mutual funds. Last year, bond funds collected $265 billion of investors’ money. This year so far, with low interest rates that aren’t going to improve anytime soon, the total bond-fund inflow is only $16 billion.

Point being, equity funds might only be collecting record-breaking assets because there’s nothing else more fruitful to do with that money.

Be that as it may, while mutual fund inflows are enormous, 2013 is on pace to be the lowest-trading-volume year in the past seven. That time span covers the rise of the real estate bubble, the subprime mortgage meltdown and the subsequent recovery in the meantime.

Bubbles are formed when a crowd gets so large it becomes unwieldy. The trader/investor crowd — according to volume activity anyway — still is shrinking from its 2009 peak.

Bottom Line

Sure, we might be due for a decent correction, and we might even be en route to a bubble. But we’re not there yet, and it could be a while until we get there, so we might as well enjoy the ride while it lasts.

Just be sure to bail out before the bubble actually pops.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

  1. stocks aren’t valued at unheard-of levels: http://blogs.wsj.com/moneybeat/2013/11/19/why-the-stock-market-isnt-in-a-bubble-in-three-charts/
  2. record $231 billion: http://www.reuters.com/article/2013/11/01/us-investing-fundflows-bofa-idUSBRE9A00M320131101

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