3 Reasons Stocks Are NOT In A Bubble Despite Recent Highs!

2013 February 26
by Kyle Bumpus
from → Economy, Investing And Investments

It happens every time the Dow comes close to a new all-time high (why people pay attention to the Dow instead of a more suitable index, I’ll never know): nervous investors flood internet forums with questions like “I have $10,000 to invest but it feels like I’ve already missed the party. I don’t want to invest it all now only to lose it in a market crash. Should I wait?” As if there’s something magical about the Dow hitting a new high. I’ve got news for you: the stock market grows over time. Hence, the Dow will always be hitting new highs eventually. It doesn’t mean stocks are due for a decline.

For the record, I don’t think stocks are in a bubble. Here are three reasons why stocks aren’t in a bubble.

3 Reasons Stocks Aren’t In A Bubble

 1.) Valuations are reasonable

Of all the stock valuation ratios perhaps the most hallowed is the price-to-earnings ratio (P/E Ratio), which is a measure of how much investors are willing to pay for a dollar of earnings. Back in the late 90′s, the P/E ratio peaked around 34, meaning investors were willing to pay $34 on average for every $1 of corporate earnings. Today, the P/E ratio over the trailing 12 months stands just under 17, or almost exactly half what it was before the tech bubble burst.

Since the late 1800′s, the P/E ratio has fluctuated wildly but has averaged around 15 times earnings. So while stocks may be slightly more expensive than the long-term historical average, they’re still only half as expensive as they were before the last big stock bubble burst. The Schiller P/E 10 ratio shows similar relative valuations. While nobody can say for certain stocks won’t undergo a major drop in the near future, it won’t be because stock valuations are outrageously high.

2.) Individual investors still haven’t piled on

Usually in a stock bubble, individual investors pile on near the top. Market timing just doesn’t work, and individual investors have absolutely horrendous timing. While there’s been an uptick in individual investors buying the last month or two, up to that point individual investors had been net sellers every month since 2009. Overall, individuals still own far fewer equities directly than they did at the market bottom. It’s the institutions (read, smart money) that has been doing the heavy buying the last few years. When individuals begin piling on and P/E gets above 20, then it’s probably time to worry. But as it stands, I don’t see any signs of “irrational exuberance.”

As an aside, check out this article I wrote about market timing right as the market was within a few months of hitting a bottom towards the end of 2008. The article is indicative of the panic prevalent in those days. The market would go on a monster bull run over the next few years and those who sold out at the bottom missed those gains.

3.) High school kids aren’t daytrading

When I was a senior in high school (I graduated in May 2000), a classmate of mine was heavily into daytrading  and even tried to convince me to try it. It was my first real exposure to the world of investing. Sure, I knew what mutual funds were and I was generally aware of the concepts of diversification, but the whole daytrading thing sounded pretty exciting. I briefly considered opening up a daytrading account with a few hundred dollars and giving it a try but luckily, my laziness saved me from losing all my money.

In retrospect, the fact that 17 and 18 year olds were even discussing daytrading stocks was a major red flag that things were getting out of control. I’m not in high school anymore, but I just don’t see that level of obsession with stocks (or the level of obsession with real estate a few years ago) right now. Well, there is that recent article I saw about a 16 year old actress daytrader who has her own website giving out financial advice, but that seems like an isolated occurrence. Tellingly, her advice on active trading seems to be geared towards taking control of your own financial destiny rather than making a quick fortune. Her advice is wrong, but at least it’s not blatantly based on greed.

Could I Be Wrong?

Of course, I could be wrong but I just don’t see it. I’m not saying stocks won’t drop significantly in the near future, just that if they do, I don’t think it’s because stocks are in a bubble. An economic crash could do the trick, for example. What do you think? Do you have any convincing arguments that stocks may be in a bubble? Leave them in the comments below!

 

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2 Responses
  1. 2013 March 6

    Joseph Kennedy once said he knew the stock market was in a bubble when the shoe shine boys started offering him stock tips. You make good points about market valuation and capital. I would add that there isn’t a sense of market euphoria. When all the pundits start saying that the market will go up and up and this time it’s different, that’s when we’ll know for sure we’re in a bubble. In the meantime, I do expect a good sized correction sometime this year. We’re due for one.

  2. 2013 March 11

    All three are great points Kyle. There is still so much cash sitting on the sidelines, this rally could be fueled a while. We haven’t even seen a shift out of bonds yet.

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