Where’s the Bubble?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 17, 2017 3:28:55 PM

and tagged Commentary

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bubbleHave you noticed how hard it is to blow a bubble these days? Things that were once considered out-and-out, no-doubt-about-it bubbles now get a “meh, I’ve seen bigger” reaction. It seems we’re all a bit jaded.

What I mean is this: the 1999–2000 dot-com bubble and bust distorted all subsequent comparisons. In light of that, current stock valuations look almost reasonable. And it’s true that by pretty much any other standard, they are very high. But they’re not as high as levels seen in 2000!

One more hill to climb?

The problem is that when prices get disconnected from fundamentals, there really is no limit to how high they can go or how long they can stay there. As a wise man once said, the market can remain irrational longer than you can remain solvent. It makes no sense to bet against a market as strong as this one.

If we accept that the market still has one more hill to climb, up to 2000 levels, we have to ask ourselves what would take us there. An advisor at Commonwealth’s National Conference last week raised an excellent point that could actually answer this question.

He asked, “What will it do to investor sentiment when the bad returns of 2008 roll off?” If the bull market continues into 2018, we will have a decade of positive returns to look back on. Almost all managers will be able to point—legitimately—at really terrific 10-year returns. Investor sentiment is already high, but imagine how much more confident investors could become, which could ultimately drive the market even higher.

The power of positive thinking

This situation is similar to what we saw in the late 1990s, when positive returns just kept feeding on themselves and pushing the market up. It also illustrates the power of positive thinking in both the investment industry and the markets themselves. Indeed, this way of thinking could be the catalyst that drives confidence—and the markets—up to levels comparable to those of 1999–2000.

You also hear echoes of this in a common argument about valuations. That is, earnings-based valuation measures (like the Shiller P/E, which I favor) look much more expensive because of the inclusion of the bad years during the crisis. This is undeniably true. But the follow-up—that when those bad years roll off, the market will somehow become less expensive—makes much less sense. How can you say a valuation measure that includes no bad years is better than one that recognizes that bad years happen? Mathematically, though, this too will happen.

The combination of “cheaper” markets and terrific 10-year returns could certainly keep pushing us higher—and that scenario is not all that far away.

Back to reality

The reality, of course, is that down years happen, as do recessions. The last time we thought we had the system figured out, that central banks had beaten the business cycle, was—wait for it—1999. Similarly, the housing cycle was widely considered beaten in 2007.

Just because prices are high doesn’t mean they can’t get higher, and the signs indicate that the markets are likely to keep moving up. If we make it to the end of 2018, we have two more reasons that might keep the momentum going.

As investors, we want to enjoy the good times but to keep an eye out for the bad ones. This is one more metric to keep an eye on. Most cycles end with a melt-up, and here is a plausible cause for the next one.

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