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Are we in a Stock Bubble?

Summary

The stock market is reaching new all-time highs, which begs the question: Are we in a market Bubble? 

There are two areas to review when thinking about “bubbles” in the stock market: the market fundamentals (valuations) and investor sentiment (or behavior).  Both of these are looking quite hot. 

On the fundamental side, the popular Shiller PE Ratio currently sits at 38.5. The only time this indicator was higher was in 2000, and you know how that ended.

And investor sentiment, in general, is pretty happy, or dare I mention exuberant? From cryptocurrencies and NFTs, to Meme stocks - investors are bidding up assets to new heights every day. Although corporate earnings are doing very well, the rest of the news is fairly bleak. Given that backdrop, I’d say investor appetite is pretty strong.

So, what should you do as an investor? Unfortunately, that’s the hard part. I know that the stock market will go down but I don’t know when and I don’t know by how much. Without that knowledge, what should you do? Continue to take a defensive stance with your portfolio. If you generally invest 75% in stocks (and 25% in bonds), keep that allocation or tweak it to 70% stocks. 

Recall the last drop of 30% in March of 2020? Stocks were on sale you that’s when you want to buy.  So be ready to take advantage of the next downturn, whenever that comes.

Photo by Chris Liverani on Unsplash

Transcript 

[00:00:00] Mike: Welcome to financial planning for entrepreneurs and tech professionals. I'm your host, Mike Morton, charter financial counselor, and financial advisor today. Matt and I discuss if we are in a bubble in the stock market, what does that mean? And what does it mean for you? Interested in more reach out to me@financialplanningpodatgmail.com.

Enjoy the show.  

[00:00:25] Matt: Welcome to real financial planning, broadcast on WK XL available wherever you get your podcasts. And in this case, maybe available wherever you get your videos. We're trying a little bit of an experiment here. This is a podcast. It's a video. It's an action figure. It's happy, fun ball. Do not taunt happy fun ball.

I'm Matt Robeson. I'm joined as always by Mike Morton of Morton financial advice. Mike, how are you?

[00:00:50] Mike: I want to get an action figure. Can we get action figures made Matt? That'd be awesome.  

[00:00:54] Matt: What would your action figure superpower be as a financial advisor? I'm hoping it would be, fiduciary related.  

[00:01:01] Mike: no  

[00:01:02] Matt: would you be able to  

[00:01:03] Mike: at all. I would be able to fix my crystal ball so I could see into the future.

[00:01:09] Matt: fix your crystal ball. I would like the ability to be able to apologize sincerely for all the things I get wrong. It'd be instantly forgiven. That'd be an amazing superpower and particularly useful for me. Speaking of people, getting things wrong, we're in one of these investing moments, that's really strange in the sense that stock market valuations of individual companies and the overall stock.

Is really high and it keeps going up. And yet the news of the world is iffy at best it's. We have the Delta variant, we have economic turbulence. We have all kinds of interesting problems with supply chain disruptions and hiring difficulties. It doesn't seem like economic news is squaring with investment and stock market reality.

My Morton are we in a bubble?  

[00:02:02] Mike: are we in a bubble?

we'll only know once it pops, we'll figure out if it's a bubble or not. It is true that the stock market seems particularly high and it's been going up and you don't have to look any further than just in 2020. What happened when the market in general is up almost 20%.

And yet, what was everybody's lives like over the last 12, 18 months? So there's definitely that to look up, but I will, say the economic news actually isn't that bad. In terms of earnings and capital reports and and business reports and things like that, the economy's chugging along.

Which is amazing in terms of earnings anyway, and the biggest companies still continue to make massive earnings and doing really positively, even given everything else that you mentioned, Matt from supply chains and labor and everything else. So I don't, I think the economic news in terms of the money.

Valuations and business is not too bad, but yes, we are in high valuations and we also have a lot of exuberance I would say recently, especially in certain sectors of the markets. And so I think it is time to just be aware of where we are in the cycle. And have some good thoughts and planning, to go forward from here, depending on what happens.  

[00:03:12] Matt: All right. You were saying a second ago that we won't know we were in a bubble until it pops, but not to sound like a Jeff Foxworthy routine. If this is going on with you, you might be in a bubble, but what are the signs that you're in a bubble? What tea leaves might you read to say, maybe we're in a bubble.

[00:03:27] Mike: Yeah there's a couple of that. I would point to one are fundamentals and one is more behavioral. So on the fundamentals, you can look at the markets or, whatever you want. Country the total stock market, certain sectors, and look at the fundamentals. So a price to earnings ratios the stock market hitting All time highs, those kinds of things.

There's many different ways of slicing and dicing data financials, earnings markets prices in terms of understanding. Where we are. So right. now on the fundamentals that we can talk a little bit more about this, but the valuations are high. We're hitting all times highs and by many valuation metrics, those are also in top percentiles, based on history.

So that's one side is the fundamentals. The other side to notice when you. Be nearing the end of a long bull run or in a quote bubble of sorts is behavior. We often, if you look back at the peaks, the market peaks from previous historical markets, there's a very happy feeling exuberance you might say about where things are headed, feeling really great fear of missing out and people piling in.

And Some of the things that you will also notice when you're at the end of a particular cycle,

[00:04:44] Matt: All right. So it sounds like data and psychology. So let's break that down for a second. Let's take the first one first. So how, from a data standpoint, how is the market measured and what does that tell you about why maybe valuations might be high right now?

[00:05:04] Mike: Yep. A lot of different ways of slicing and dicing markets. So I'm just going to mention two that are very popular. One is the SMP 500 trailing PE ratio. So we talked about the PE ratio. That's the. Of the market or the price of particular company, but this case, we're talking about all 500 of the biggest companies.

So the price of all those 500 companies divided by the earnings of those companies, and that gives you a ratio. So it's like how much are you paying. For those earnings, right.

That's the ratio, what's the price I have to pay for that stock. Given all the earnings that those companies are spitting off.

How much are you paying for those earnings? And we're particularly high right now. It's currently about 34 and a half. That ratio, the historical average is six. So we're more than double the historical average. Now you can argue maybe history doesn't make as much sense as it used to given productivity and technology. Okay.

I'm not going to have that argument today, But you're still more than double the historical average of your 12

month PE.  

[00:06:09] Matt: You're saying. The way we thought about price, earnings ratios, how much you're paying to get the earnings and the income and the value of the company. It may not make as much sense now because the intrinsic value of companies is different somehow under our current technological circumstances, is the nub of it.  

[00:06:30] Mike: So if the historical average is 16, which means sometimes below 16, sometimes above 16. Now, if you look at graphs over the last hundred, 200 years, you will notice that. You always are above or below that 16, of course, but that's the average. So you're spending half the time time above that.

And so we've been above that for quite a long time. Now we've barely reached that historical average, even in the troughs from like 2000, 2009. And so there's an argument to be made that people are willing to pay more. That's the price for the same earnings than they used to be. it.

could be more participants in the market. And up the price. But there's a trend line that you can look over or 40 years. We've been above the last 150 years where  

that 16 comes from.  

[00:07:12] Matt: Got it. All right. I want to circle back to this idea of people being willing to pay more for the same underlying value, but I don't want to take you off track. You said a moment ago that there are lots of different ways to look at the market. Others you want to cover before we  

Hit the psychology side.

[00:07:26] Mike: yeah, just one other ones to smooth out so that PE ratio can bounce around quite a bit because earnings, depending on the economy is very cyclical and you may have heard of cycles. Schiller the Nobel laureates professor from Yale came up with the Shiller PE ratio. This smooths it out with a tenant.

Average. So it takes 10, it's called the Cape Shiller PE ratio and it takes 10 years of earnings to kind of smooth out this line, but it's the same exact idea. Okay. And so there, we're almost at 40, so it's a 38.5. In terms of the Shiller PE ratio and the highest ever was peaked over 40 back in 2000. so we're very close to that 40, if you remember 2000. And so again, there's another metric that this is the second highest it's ever been. So that's just, an  

indication of potential  

overvaluation of.  

[00:08:15] Matt: All right. So that's what the data's telling us. But you mentioned that there's the the market psychology of it. Let's just hit that broadly for a second. I have a feeling we're going to circle back to this question. We put in the parking lot of, you know, are people just willing to pay more for some weird, you know, kind of reason.

So investor behind. What does that mean? How does that factor in, how do people's perceptions  

weigh into this whole equation?  

[00:08:42] Mike: So remember that markets are  

made up of  

humans. Okay. So

[00:08:46] Matt: except for those robo-advisors  

that

we were just talking about a few weeks ago.  

[00:08:51] Mike: That's right. Robots doing some buying and selling for you and there's hedge funds and high-speed traders and all kinds of stuff, but everything's by humans. So humans are, , doing the buying and selling.

And if you look at a traditional economics, of course, we try to say, everybody's going to be completely right. with a bunch of theories from there. Well, your fundamental assumption is kind of incorrect. We know humans are far from rational. And made up of humans doing the buying and selling, , the supply and demand. Then things can irrational. And so we all sort of understand that. So how does that play into a valuation of markets and potential? Bubbles are being, you know, high? Well, When mood is very positive, And Whatever that means in terms of the positivity you want to get into the market and say, look, Yeah.

I think This is going to continue to go up because I'm very positive and what we say bullish on the market.

And so your demand is outstripping supply. And so when demand is outstripping supply prices go up. And so therefore the market goes up when humans and  

individuals become very positive about the near term.  

[00:10:01] Matt: This reminds me a little bit of Donald Trump saying that the value of his company depended a great deal on his mood when he woke up that morning, which sounded sort of ridiculous, but in a very real sense isn't I mean, look, you and I came along at a time in sort of our educational trajectory when. The behavioral economics revolution that was pioneered by Daniel Kahneman and Amos Tversky in the 1970s.

Hadn't really fully filtered its way into the way economics econ 1 0 1 was taught now you and I attended the school. College. And we studied economics there at about the same time. I don't remember covering an awful lot of behavioral economics. I remember covering an awful lot of classic market economic sell, you know, supply and demand and that kind of thing.

But of course, since that time, we have learned a lot about these kinds of biases and human foibles and all kinds of perception issues that people have, where it really does become a matter of. Mood collective mood. And so what I'm hearing you say is that on the one hand you you've presented these two sides of the coin, right?

There's the data and the psychology. And the question on the table is, are we in a bubble? So the data seems to suggest historically, Yeah, we might be in a bubble, but the psychology, it sounds like you're saying look, if people are feeling good, then it makes kind of these sky high valuations real in a in a market sense.

And so there's no reason to think that we're in a bubble or that  

we're going to face a pop.  

[00:11:40] Mike: But

you're close. Yes, exactly. Right. that's why the market is where it is. it makes sense. earnings are doing well. some big companies are still making a massive amount. , lots of people still have jobs and making lots of money. There's still a lot of that happening. And so people feel good. The other thing that people feel good about is having excess cash. There's a lot more. Then people have had, So you can do measurements on, total net worth and, available cash. And so that's at all time, highs, debts are down. So people are feeling very positive and investing that.

So that's where you get the exuberance of, cryptocurrencies. Oh, it's this new thing that people are piling into and feeling pretty bullish on NFT. If you've heard of those, these digital, tokens are are skyrocketing. So you've seen these different pockets of things that sound kind of crazy collectible sports cards that are digital, that you pay hundreds of thousands of dollars for, you know, people could like shake their head, but that's what, is getting paid for. and so you might have shaken your head at same, artwork from, you know, a hundred or 200 years ago. Oh, someone would pay that just for like some painting. Well, it turns out, that it did rise in value, so I'm not commenting on. Oh, our cryptocurrencies are NFTs. Just going to be a bubble and go to zero. I have no idea. What I'm saying is people are very bullish and positive and bidding these things up, and they're very, excited about them. So to answer your question, though, at some point, people become a little less excited. All right. Whether it's news about the Delta variant people shutting down or mass again, or it's something else that comes in sideways.

I mean, we could have had this conversation two years. And like, oh, the market's pretty good value, you know, pretty high value and people were pretty excited and then a pandemic happened. Like we have no idea what might come next from politics, the world situation, whatever it is, but something's going to happen.

That makes everybody a little less happy, a little less exuberant. And that's literally the definition of the peak. It's not that you're not

happy.  

It's just, Everyone's a little less excited about the future than they  

were the day before. And that's literally the peak.

[00:13:37] Matt: Yeah. All right but let me kind of throw back at you the idea of, if we go back to the original question here, are we in a bubble which does matter as from an investor standpoint, right? I'm sure all your clients are kind of worried about this right now. If we're at the peak, , I know your advice is always as, as good advice, stick with it, have a long-term investment strategy.

Don't try and time the market. You're probably going to be wrong, but of course people are going to be concerned if we are. At a peak. And if we're in a bubble that's about to pop. I guess what I would say though, is that to the very real extent, going back to our parking lot item about, Hey, people may simply psychologically be willing to pay more in these PE ratios than they were in the past.

People feel differently about it. Isn't there an argument there that, that kind of casts the data. In a new light, it suggests that there's not necessarily a reason to look and say, is suggestive of a peak in itself. Granting of course the world can change. Bad news can happen and people can sour awfully quickly.

[00:14:46] Mike: sure. I think, I would tend to agree with that statement. remember that the evaluations I said are more than double the historical average. So we used to spend 50% of our time below 60. And 50% above 16. And we're now at 34. So I think that, , if we look back 50 years from now and say, wow, what was the, what happened from here for the next 50 years?

We might be the whole time above 16. Potentially, like you said, people are willing to pay more now, but I don't think that we're going to be  

averaging 34. Which is where we are now. Okay. So yeah, I think, there might be some merit to the argument, but  

I still think the data says that we're in a high valuation stage.

[00:15:27] Matt: Circling back at the top of the show, we were sort of spit balling about what superpower we would have if we were suddenly turned into action figures. And I suggested that the superpower I would like is to be able to apologize for the things I got wrong and immediately be forgiven. So if I've taken.

Down a wrong path here, then I apologize. And I hope our listeners will immediately forgive on the other side of it.  

You wanted to have a perfect crystal ball. So Mike Morton look into your perfect crystal ball. What do you

think is going to happen  

[00:16:00] Mike: Matt. I wish I  

had  

that superpower, but my crystal ball is still  

broken,  

[00:16:06] Matt: No, I'm holding you to this superhero.  

Mike Morton.

[00:16:08] Mike: but what's going to happen next. All right. I'm going to tell you what's going to happen next. The market is going to go. Down or sideways from here.  

And it will do that in the next few weeks, few months, few  

years.

[00:16:23] Matt: my gosh. You're like  

Ron Swanson giving out personal information. My son was born within a certain amount of time. He weighed a certain number of pounds and ounces. all right.

go on. Something will happen.  

[00:16:33] Mike: something will happen. And this is really the issue. So now we're getting into all right. If we are in high valuations, we talked about, we are, if we're in a place where people are pretty excited to bid up prices of various assets, which we are, then what do we do from here? What can an investor do? And this is really hard because you have to be able to predict multiple things. You have to be able to predict how much longer it goes from here. When does it. Okay. If it does pop, where does it just fizzle? Okay. When does that happen? So you have to be able to predict that is that next week, six months from now two years from now, and you have to predict, how far does it go down?

 If it goes down, does it go down 10%, 20%, 40% from whatever that high is at that time. So now you can see the quandary, that individual investors that are in both when it's going to happen and how much it's something might happen Now I can guarantee. That the market will go down at some point in the future. Okay. But I can't answer either of those two other questions. So what are investors to do? I think right now is a good time to be defensive. Now, when I say defensive, I definitely do not mean sell everything and put it in cash. Do not, do not Do not do that. In fact, Maybe do nothing is still the answer.

Okay. If you have a good allocation between stocks and bonds, you're at 70% stocks stay there. when I say defensive, maybe go 65% stocks. I'm saying tweak the dial. Okay. I tend to tweak the dial for my clients by five to 10%, either direction right now being defensive. Let's, you know, tweak it a little bit out of the  

stock market by five to 10%. and that's my low forever. If you're normally 80%,  

maybe we tweak it to 75, 70% and that's it. That's my market move until it goes down. But I don't know if that's, next week, six months or two years from now.  

[00:18:24] Matt: Given where we are the high valuations, some of these risks, some of the potential that when you are living in a bubble and it may pop, are there opportunities, are there particularly good places to invest?  

[00:18:37] Mike: Yeah. Now, we're back to the fundamentals and looking at valuations, and there's two places in the market that you can potentially, again, tweak that dial. We're not saying, put in tons of money or anything like that, but if you're normally, um, 5% in emerging market, You could up that, to 10% emerging markets as an area that's still historically pretty cheapish.

 When I'm saying these things also met, I'm not saying for the next quarter or the next year, I'm talking the next five years. I mean, you know, change your allocation to emerging markets. If you have zero right now, you could put in 5% and keep that for five. You know, th that's the cycle of these things. So that's why I'm talking about tweaking the dial and then just seeing what the markets give you over time. So emerging markets is one of those and the other is the value side of the U S stock market, large value or small value, just the, the value companies versus the growth companies.

They're at historical  

historical lows, um, compared to the growth company. So again, you could tweak  

that dial a little bit and move a little money into

those, and you'll be.

[00:19:42] Matt: quick lightning round question. Thinking about bubbles and the psychology of investing and behavioral economics changed any of your outlook when it comes to the long view, not kind of these short-term,  

how do I Dodge the pop, but sort of the, long-term how you look for value and understanding that bubbles and enthusiasm and exuberance are going to arise from time to time and mark.

[00:20:11] Mike: Yeah, no, that's a great question. I think in general, the market is  

still reflective of fundament.  

Companies that make great products that sell at high prices and everybody wants, will be worth a lot companies that do not do that will slowly go to zero. So I think the fundamentals do matter. I think though the behavior and not so much human behavior, which is the same for hundreds of years, but more the access to technology and access to markets is making these things very rapid.

What I mean is  

making markets go up and down  

extremely quickly. and with a lot of momentum in both directions. And I think you'll  

continue to see that more often, such as March of 2020, how fast that moved.  

[00:20:50] Matt: so the best advice might be just to be prepared for the, the swings even more than you were before and keep taking that long-term view. Mike Morton, Morton financial advice. Thank you so much as always for being with us on WK Excel  

[00:21:05] Mike: my pleasure.

Thanks for joining us on financial planning for entrepreneurs. If you like, what you heard, please subscribe to and rate the podcast on Apple iTunes, Google play Spotify, or wherever you get your podcasts. You can connect with me on linkedin or mortonfinancialadvice.com. I'd love to get your feedback. If you have a comment or question, please email me at financialplanningpod@gmail.com. Until next time thanks for tuning in