A little more than 1½ years ago, I wrote an article for the Bradenton Herald about whether the stock market was in a bubble phase because of excessive speculation. At the time, the financial media were obsessed with talking about stocks being overvalued, and how the bursting of the bubble was soon to come.
As usual, the talking heads were wrong, so let's review where we are today with stock prices higher than they were back in late 2013.
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 every few years. These corrections keep the market from becoming too speculative in nature, which eventually results in a very overvalued market. True bubbles occur less frequently and usually result in price declines of 50 percent or more.
The Dutch Tulip Bulb Bubble of the 1600s took prices on a single bulb to 10 times the annual salary of a skilled craftsman! Prices subsequently collapsed by close to 100 percent and never recovered. Stock price bubbles of note occurred in 1929, 1968 and 2000. Note that I don't classify 2008 as a stock bubble; rather it was a financial crisis that caused prices to decline as opposed to an overvaluation of stock prices.
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What is interesting about the current rise in stock prices, which has been going on for six 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 about 17 times earnings. This isn't cheap, and we have to admit that stocks are pretty fully valued. But by way of comparison, back in 2000, the price to earnings ratio for the S&P 500 reached 30, almost 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 about 2.3 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 that causes momentum to shift from up, to down. Usually it is the Federal Reserve, whose mandate to control inflation leads them to raise interest rates and reduce monetary liquidity in the financial system.
While the Federal Reserve has widely telegraphed that it is considering when to begin raising short-term interest rates, its first few increases will still leave the federal funds rate at very low levels. It may be a while before bond yields start providing serious competition for the attention of investors.
From the standpoint of being reasonably cautious, I remind our readers that market corrections of 10 percent or more tend to occur about once every 18 months historically. Things have been unusually quiet over the last few years, and we know that rising markets don't last forever. The prudent investor should be considering risk control as a larger priority today than back a few years when prices were much lower.
Tom Breiter, president of Breiter Capital Management Inc., is a registered investment adviser. He can be reached at 941-778-1900 or by e-mail at: email@example.com