The Independent Market Observer

Is the Stock Market in a Bubble?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 27, 2021 4:10:57 PM

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stock marketThere has been a lot of talk about whether the stock market is in a bubble. As usual, there are distinguished professionals on both sides of the debate, armed with convincing statistics and arguments. So, what is the average investor to do? We do what we usually do: try to understand the facts of the situation. Let’s start by asking ourselves what a bubble is, as this is the unavoidable first step in deciding whether we are in one.

Bubble Defined

There are multiple definitions. The essence of them all is that asset prices have gotten to an unsustainably high level, driven by ridiculously positive expectations on the part of investors, and that when those expectations change (for whatever reason), prices will revert to something normal, dropping a lot in the process. If you think back to the dot-com boom and the housing boom, you see that this definition captures both very well.

Let’s start with the root question: are stock prices at an insanely high level? Almost every price-based indicator says yes. Whether you look at sales, book value, earnings, or any price-based metric at all, stocks are not only incredibly expensive but close to as expensive as they have ever been. For many analysts, this fact closes the case.

Interest Rates and Stock Prices

There is, however, another way to look at stock valuations, and that is to compare returns instead of prices. This approach acknowledges the fact that stocks do not stand alone in the financial universe but, rather, compete with other assets—specifically, bonds. The more bonds are paying in interest, the more attractive they are compared with stocks. For an investor, there is, therefore, a direct relation between interest rates and stock prices.

Think about it. Over time, the stock market has returned around 10 percent per year. If you could buy a risk-free U.S. Treasury bill giving you the same 10 percent, wouldn’t you buy that instead? Why take the risk involved with stocks if you don’t have to? And that investor aversion would push stock prices down until the expected return was enough to compensate for the risk. Interest rates up, stock prices down.

Similarly (and relevant to where we are now), if interest rates are low, stocks are more attractive. If you are getting 2 percent from your bonds, then you are giving up much less when you trade them for stocks, and you can and will pay higher prices for stocks. Looked at another way, with rates lower, the present value of future earnings of a stock is higher. Either way, when rates go down, you would expect stocks to go up. And this relationship is what we have seen.

Investor Exuberance: Shiller Says . . .

Given this fact, the question now becomes whether current stock market prices are about lower rates, instead of investor exuberance. Robert Shiller, the Nobel prize-winning economist who wrote Irrational Exuberance, did just this calculation. Shiller points out that with interest rates where they are right now, on a relative valuation basis, stocks are not that expensive at all. In other words, current prices could well be a rational response to low rates, instead of irrational exuberance. Not a bubble, but simply a result of changed policy.

Mind you, he is also the source of the Shiller ratio, which is the basis for one of the most compelling price-based bubble arguments. So, in a sense, he is on both sides. But the reason, I suspect, that he came out with this new analysis is that it simply has proven to be true over the past decade.

When you look at price-based measures, over the past several years they have been consistently at or well above historical levels—and that premium has grown further as interest rates declined. Even in times of market stress, valuation lows have still held at or above levels that were highs in history. The fact is, we are now living in a higher-valuation world, which makes the historical price comparisons less relevant.

What If Sentiment Changes?

Looking at this analysis, we can conclude that current valuations, while high, are not necessarily unsustainable and not driven solely by investor sentiment. Which brings us to the next part of the bubble question, which is whether prices will inevitably drop once sentiment changes. Since a large part of what appears to be driving prices isn’t sentiment, the answer is likely no. While in many respects the stock market looks like a bubble, the underlying foundation is different. This is a very expensive market, but it's likely not a bubble. That doesn’t mean it can’t go down, of course, potentially by a lot.

What If Rates Rise?

We still have an open question, for example, of what happens if rates start to rise. This is a real risk, but the Fed has said it will be some time before it lets rates go up. Any rate increases are likely to be slow and measured, which will give markets time to adjust. That said, higher rates would affect the markets, reversing the trends that have gotten us to this point.

The other open question is that sentiment is indeed very positive, and the effects when it changes are likely negative as well. Beyond the headlines, however, if you look at volatility and P/Es (as we do in the Market Risk Update every month), sentiment is not as positive as all that. Could it have an effect? Certainly. Would it sink the market? Not necessarily.

Not a Classic Bubble

Big picture, there are reasons to believe this market is not in a classic bubble. Does this mean we won’t see a market decline? Of course not. Even in the absence of a bubble, markets can drop significantly, as we have seen multiple times in the past decade. Bubble or not, we can certainly expect more volatility, because whatever happens with interest rates or sentiment, that is one thing that will not change about markets.

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