Since the financial crisis almost a decade ago, the stock markets around the world have been moving higher and those invested have experienced good times. Yet as the markets continue to grind forward, we are observing more frequent opinions that the stock market is at bubble levels.
Behavioural finance theory attributes stock market bubbles to cognitive biases that lead to groupthink and herd behaviour. The Fear of Missing out (FOMO) is an emotional response that occurs late in a stock market cycle.
A stock market bubble is a type of economic bubble that occurs when investors drive stock prices well above their value, relative to normal stock valuation.
We believe in looking at the facts first, rather than hyperbole. Valuation helps us to understand if a bubble is imminent and a reasonable place to start on valuation is to look under the hood of the S&P 500 benchmark (aka “The Markets”).
The most common method of assessing valuations is by using a financial ratio called the Price Earnings ratio (“P/E”). Simply put, the P/E of a company measures the current stock of a price (the P) divided by its earnings per share (the E). The P/E of the S&P 500 index represents the P/E for all the members in this index.
The average P/E of the S&P 500 index over the past 30 years is 19.15 times. The current P/E of the S&P 500 is 21.40 times. By historical measures, one could say The Markets are slightly more expensive than the long-term average. Circled below in red, are periods when The Market P/E was in bubble territory and shortly afterwards, it frankly popped. The Y2K DOT COM bubble and the 1991 Japanese asset price bubble are highlighted. Both events resulted in prolonged market declines.
Source: VIP Wealth Solutions and Bloomberg
Some investors are wondering will history repeat itself and will another bubble be imminent?
Now a word of caution – nobody can accurately predict the future with consistency, yet we observe that the scary month of September was not that scary.
Friday, Sept 29, 2017, marked the nine-year anniversary since the DOW suffered its worst points decline on record. That occurred after the House of Representatives rejected a $700 billion bailout plan. The blue-chip index slumped just over 777 points and roughly $1.2 trillion was wiped off the DOW Jones stock market value. The House passed a new bailout package just days later, and since then, the Dow has risen 116%.
Stock markets have managed to clock steady gains and set new records even as tension between the U.S. and North Korea threatened to spill over into warfare. The second-quarter earnings season, which occurred earlier in the third quarter, was generally positive. Already, expectations for the third quarter slowdown in US GDP have been tempered, after the trifecta of hurricanes Harvey, Irma and Maria battered the southern U.S. and the U.S. territory of Puerto Rico. Crude oil has managed to average close to $50 price levels despite a peak to trough levels decline of 24%.
Despite these positive facts, it seems everyone’s suddenly an expert with opinions on why the stock market is doomed, or the consumer is tapped, or the USD dollar is dead. The media today seems to be only reporting the dark side or negative news. News used to be balanced with a summary of both good/friendly items and bad/dark issues. Listening to all of this darkness today and reacting, goes back to the crux of investing:
Investing requires you to not just get the “what” right, but also the “when.”
In the financial markets, things have a tendency not to matter ... until they do. Before they do matter, data shows up in the facts, and that’s when you should pay attention. In the meantime, keep the bogeys on your radar screen, but don’t overreact … They could turn out to be friendlies.
Thanks for reading enjoy the day.
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