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The Market Is Not In A Bubble.

  • Written by Syndicated Publisher No Comments Comments
    November 27, 2013

    Bubbles are rare events. There have been 25 bear markets over the last 110 years, or one on average of every 4.4 years. Their average decline was 36.5%. The ten largest declines averaged 49.9% for the Dow.

    Only three, perhaps four of the 25 were considered to be brought on by bubble conditions.

    In by far the majority of cases the market had simply become overbought and over-valued in relation to economic conditions and earnings and needed those excesses to be corrected.

    That is the current situation.   

    As shown in the following table, prior to the market bubble in 1998 and 1999, any time the P/E ratio reached the vicinity of 20 it was at risk of a bear market taking place. The table shows the subsequent declines (and the P/E ratio at the subsequent bear market lows.

    The S&P 500 is currently selling at around 20 times trailing earnings.

    Not that the P/E ratio can be used as a ‘sell signal’. The P/E ratio can remain at a high level for quite some time, or move higher, before the market finally tops out. That was made abundantly clear when the market continued to climb in its record 1999 bubble and the P/E ratio reached an unheard of 42.2. But except for that bizarre and unusual event, a high P/E ratio could be taken as an indication of high risk.

    It’s not as simple these days. Beginning around 1998, as the record-breaking 1990’s bull market reached ‘bubble’ conditions, and the P/E ratio climbed well past previous highs and the market did not roll over into a correction but powered still higher, the P/E ratio based on ‘trailing earnings’ was disparaged as a method of gauging valuation.

    Wall Street and corporations needed a method that would downplay the soaring P/E ratios that had analysts concerned that the market was grossly over-valued.

    So it was suggested, and soon acceptable and popular, to express P/E ratios as the ratio between the share price and Wall Street’s ‘estimates’ of future earnings.

    (When even by that method the P/E ratio reached never before seen levels, Wall Street began claiming that P/E ratios didn’t matter any more).

    A different method of calculating the Price/Earnings ratio was developed by Robert Shiller, winner of the 2013 Nobel Prize for Economics. He introduced it in 2000 in his book Irrational Exuberance.

    It’s based on the average inflation-adjusted earnings of the previous 10 years, and is known as the Cyclically Adjusted PE ratio, or CAPE ratio.

    As of October 31, 2013, it was at 24.75, the high end of its historical average. However, it reached 27.31 at the time of the market top in 2007, and 43.22 at the market top in 2000.

    So here again we have a measure of market valuation that is at the high end of normal historic market conditions, but not at bubble market levels.

    And then there is what Warren Buffett says is “probably the best single measure of where valuations stand at any time.”

    It compares the total price of all publicly traded stocks (total market capitalization) to the nation’s total economic output, or Gross Domestic Product (GDP).

    GDP is determined quarterly. As of September 30, 2013, total market cap was 112.9% of GDP. That is also on the high side of the market’s historical valuation. In fact, it is as high as at the important market peak in 2007, just prior to the market meltdown in the 2007-2009 financial collapse. But it is not near its 2000 market bubble peak, when the percentage reached 150%.

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    So I disagree with those describing  current conditions as a bubble.

    However, as noted at the top of this post, by far the majority of bear markets take place well before the market reaches bubble conditions, simply when the market becomes overbought and over-valued in relation to economic conditions and earnings.

    Other conditions present at those previous tops included an extreme level of investor bullishness and confidence. That condition is in place now, indicated by the likes of the Investors Intelligence Sentiment Index (an average of 54% bulls, 16% bears over the last four weeks), the level of margin debt, and the near record flow of retail investor money into stock mutual funds this year after pulling money out for the first three years of the bull market. VanGuard reports that investors now have a 57% allocation to stocks, a level only surpassed twice in the last 20 years, in the late 1990’s and in 2007.

    Yet, the market has reached this condition thanks to the support of the Fed. And in spite of the Fed’s concerns that to continue with the stimulus does risk that it is beginning to blow another market bubble, it continues to postpone the inevitable, and is likely to continue to do so until next spring.

    And we are in the market’s favorable season, although that didn’t mean much in 2000 when the Dow topped out in January, or in 2007, when it topped out in October (although it did recover some each time before the favorable season ended).  

    But obviously it isn’t necessary to agree or disagree with whether the market is in a bubble or not, to conclude that it is at high risk of at least another short-term pullback to at least test short-term support levels.

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    And it certainly has us watching our currently positive intermediate-term technical indicators closely on concern that a short-term pullback could deteriorate into something worse.

    Other Voices:

    No shortage of opposing opinions.

    Vito J. Racanelli, Barron’s: “The market is upbeat. Expect it to stay strong as investors become inured to Federal Reserve tapering rumors. Who’s afraid of the tapering wolf? Fewer investors than before, if last week’s equity and bond action is anything to go by. Both stock and bond prices fell sharply after the release of the minutes Wednesday, in which the Fed reiterated that economic trends would warrant a reduction in stimulus “in coming months.” Nevertheless, by Friday’s close, equities had recovered all the ground and then some. Rick Fier, a trader at Conifer Securities in New York says “The reaction was “short-lived and that suggests the market is getting comfortable with the taper.”

    Michael Santoli, Yahoo Finance:The great phony bubble scare of November 2013 is blowing over, but further corporate-profit growth is necessary to support the market near record highs. Even a gentle “second wind” for earnings growth, which we could see, would better support the indexes and keep further gains from being spun dangerously on hopes and risk-seeking cash alone. . . . .  You’ve heard the talk that stocks are now in or will soon enter a bubble, with warnings of varying urgency coming from Carl Icahn, Jeremy Grantham, and Doug Kass.  . . . .. .  .. . . . Well, as Barry Ritholtz of Ritholtz Wealth Management and others have correctly noted . . . because so much worry has been aired, the chance we’re in a bubble is inherently diminished.”

    Jason Zweig, Wall Street Journal: “Whether stocks are overvalued or fairly priced isn’t the question that investors should be asking. Instead, what you need to answer is this: How much can I stand to lose . . . .  Let’s say you have $400,000 in stocks and stock funds. Between November 2007 and March 2009, U.S. stocks fell 51% and foreign stocks 57%, according to Morningstar. Another such “drawdown” would shrink your portfolio by more than $200,000. . . . . . David Salem, chief investment officer at Windhorse Capital Management says, “. . . . . . History is littered with people who chased return on the way up, and then ended up converting what should have been temporary decrements to wealth into permanent losses by abandoning assets at the bottom.”

    Fran Kinniry, VanGuard Investment Strategy Group: “Investors continue to chase performance. . . . . . . . . . For the first time since the onset of the global financial crisis—significant positive cash flows into stock funds and negative flows out of bond funds. . . . . But this isn’t necessarily the smartest move. Instead he suggests investors look at their asset allocation and direct more money into bond mutual funds. “It is very common following significant gains in the equity markets for investors to question the benefits of rebalancing. Perhaps they think that “it’s gonna be different this time.” While it might be, it is much more likely to be the “same as it ever was.”

    Tobias Levkovich, Citigroup: “A quick perusal of our summary dashboard signals is not that inviting for the S&P 500 despite an accommodative Fed, and still positive credit conditions, and longer-term valuation metrics. Sentiment is now warning of a euphoric investor base while the Citi Economic Surprise Index and intra-stock correlation are also posting worrisome signs. . . In the past, sticking with the disciplines has served investors well and there does not seem to be a need to alter the “conditional probabilities” approach just to fit in with current enthusiasm.”

    Steven Russolillo and Alexandra Scaggs, Wall Street Journal: “Wall Street strategists have a reputation for being stock-market cheerleaders, helping to boost sales of stocks at their brokerage firms. Since 2000, stocks have returned an average annual gain of 3.3%, well below the 10% predicted each year by strategists. Every year they predicted stocks would rise the following year, missing all four down years that stocks plunged.”

    Stocks have only averaged a 3.3% annual gain since 2000? Well, yeah. Actually less. The S&P 500 is just 18.7% higher than at its peak 13 years ago on a buy and hold basis, or an average of 1.4% a year.

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    By contrast our Seasonal Timing Strategy is 161% higher than in 2000, and while taking only 50% of market risk, and seeing its worst years so far a 3.6% decline in 2008, and a decline of 4.2% in 2009. It has done a superb job of missing the big declines.

    To read my weekend newspaper column click here:  The Fed Is Backed Into A Corner

    Images: Flickr (licence attribution)

    About The Author – Sy Harding, Street Smart Report

    Sy Harding publishes the financial website Street Smart Report Online and a free daily Internet blog at Sy’s Free Blog. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!

    It includes our research and analysis on the economy and markets, and provides charts and buy and sell signals on the major market indexes, sectors, bonds, gold, individual stocks and etf’s, including short-sales and ‘inverse’ etf’s.

    It provides two model portfolios as guides. One is based on ourSeasonal Timing Strategy, one on our Market-Timing Strategy.

    In depth updates are provided every Wednesday, with interim ‘hotline’ updates every time we make a trade. An 8-page traditional newsletter Street Smart Report is provided on the website every 3 weeks, in pdf format for viewing or printing out.

    There is the Street Smart School of online technical analysis ‘seminars’,commentaries to keep you ‘street smart’ about Wall Street, and much more. 

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