Are stock prices in a bubble?

November 12, 2013 

Almost every day for the last few months we have seen stories on financial websites, and in print prognosticating that the stock market is a bubble waiting to burst. Given that the market has more than doubled in price since the lows of the 2008 - 2009 financial crisis, perhaps it is time to take a look to see if investors are getting in over their heads.

Bubbles in asset class prices include irrational behavior by a majority of investors who get swept up into believing that prices will continue to rise, and they ignore all fundamentals of business and economics. We are not talking here about a normal bull-bear stock market cycle where corrections of 10 to 30 percent happen with fairly regular frequency on cycles ranging from 3 to 6 years. True bubbles are less frequent.

The Dutch Tulip Bulb Bubble of the 1600's took prices on a single bulb to 10 times the annual salary of a skilled craftsman. Prices subsequently collapsed by close to 100% and never recovered. Stock Bubbles are a bit more frequent with notable peaks occurring in 1929, 1968, and 2000.

What is interesting about the current rise in stock prices, which has been going on for 4 ½ years with the exception of a pause in 2011, is that stocks do not appear to be in bubble territory based on valuation. Currently, using reasonable estimates for earnings in the next year, the S&P 500 index is trading at 15 times earnings. Back in 2000, the price to earnings ratio for the S&P 500

reached 30, double the current level of valuation.

Also, back in 2000 interest rates on government bonds were at 6 percent, providing a lot of competition for overvalued stocks when it came to the attention of investors and where to put their money. Today, government bonds yield 2.6 percent, just a little more than the dividend yield on the S&P 500.

The other thing that some prognosticators have trouble recognizing is that rising stock markets usually don't die of old age alone. In almost every case there is an external influence which causes momentum to shift from up, to down. In most cases this is the Federal Reserve whose mandate to control inflation leads them to raise interest rates and reduce monetary liquidity in the financial system.

This usually occurs after an economic recovery has been in place for 4 or 5 years historically, but there have been cases, like the decade of the 1990's where stocks rose for 8 to 9 years before succumbing to rising rates and a very over-valued market.

As pointed out above, there does not appear to be a dramatic over-valuation of stock prices presently, and the Federal Reserve appears unlikely to raise interest rates significantly in the near future. In short - I don't see the precursors for a "collapse" of stock prices that one would expect from a bubble.

However, it is important to realize that corrections in stock prices of 5 to 15 percent are normal and happen in most years at least once. Since we haven't had a pullback of much over 5 percent since late 2012, I would not be surprised to see one occur in the next few months.

Tom Breiter, president of Breiter Capital Management, Inc., a registered investment adviser, can be reached at (941) 778-1900 or by e-mail at: tom@breitercapital.com

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