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Stock Market Bubble 2017: Is The Stock Market In A Bubble?

Steve Pomeranz, Is the stock market in a bubble?
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Stock Bubbles Are Tough To Call

I can’t tell you with any certainty whether the stock market is in a bubble, and neither can anyone else, including economics gurus and seasoned market veterans. I begin with this admission because I am asked this question all the time, and it clearly has serious ramifications for my clients and listeners alike.

Even though we have decades of experience, expensive educations, and boatloads of information, at the end of the day all anyone can do is to try to form a smart opinion about the possibility that the market is in a bubble—an opinion, not an objectively true conclusion.

We can use market theories and history, circumstantial evidence, and data points to try to get at the problem of diagnosing a bubble.  But the most important related questions (Which stocks are in bubble territory? When will the bubble pop? How far down will it go?) remain elusive. If I could answer these questions and predict their timing, I would mint a fortune for myself and my clients, but there are good reasons why I’m not waiting around for that to happen.

It’s common to hear people talk about such-and-such bubble after a market crash as if it should have been obvious all along based on crazy price-to-earnings ratios or some other simplistic metric like all time high market values.  However, in this case, hindsight may not be as 20/20 as we think it is.

Do P/E Ratios Tell The Whole Story?

If you follow financial media and its pundits at all, you’ll hear a lot about how Price-to-Earnings ratios or P/Es as they’re known, are reliable indicators of stocks being either under or overpriced, or even in a bubble. Time and again the market has defied the conventional wisdom about this approach to valuation. There are myriad examples of publicly traded stocks with very high P/E ratios and exploding stock prices. Looking at P/E alone, many would say such stocks may be not just expensive, but full-on bubble expensive. While its stock price will surely fluctuate, betting against a stock could be risky too. The lesson? Be careful about gauging bubbles based on P/E.

Robin Greenwood And The Definition Of A Bubble

As you’ve probably guessed by now, it turns out that bubbles are difficult to describe and quantify. Harvard Business School economist Robin Greenwood has made the study of stock market bubbles his academic focus. In an interview with Bloomberg.com podcast “OddLots,” Greenwood talked about his efforts to come up with a working definition of a market bubble. He describes how most economists won’t even use the “B word” because they’re not convinced bubbles are an actual thing or that they can be rigorously defined, which in academic circles amounts to the same thing. By looking at the history of market runups and crashes going back a century or more, Greenwood has tried to uncover criteria, a concrete set of measurable features that sets bubbles apart from typical bull-and-bear market cycles. Needless to say, P/E ratios or historic high prices are not among these features.

Among the most promising common denominators, he has found during his research is something he calls acceleration and issuance.  Acceleration refers to the increase in stock prices, expressed as a rate of price increases. When stock prices rise by a certain amount—say 20%—within a certain amount of time— say one year—and this is greater than the previous year’s price increase, we can say that acceleration is getting faster. Greenwood argues that historic data show that unusually rapid acceleration is a signal confirming a bubble. Issuance is simply the number of new stocks entering the market via Initial Public Offerings or IPOs, as they’re known. He also includes new stock creation from existing publicly-traded companies. According to Greenwood, bubbles are marked by a big ramp-up in issuance as the market marches towards a peak. But not every acceleration causes a bubble because his research suggests that many market rises which then crash do not include these two characteristics and, therefore, don’t deserve the bubble label. Confusing? You betcha! That’s why it’s so hard.

Tell-tale Sentiment Factors

There are other features of bubbles which Greenwood is studying, some of which are harder to quantify because they are based on the sentiment of market participants. It is common to hear about bulls or bears “capitulating” or surrendering and selling everything at the bottom because the market has gone so far against their idea of the way things work. Greenwood talks about how sentiment among investment professionals shifts during a bubble’s rise. Starting out avoiding risky investments by sitting on the sidelines, they eventually join in the risk-taking because of the intense pressure they feel from clients to not miss out on the tremendous gains in the market. Needless to say, many of these pros and their clients have been burned badly by showing up late to the party, buying stocks near the price peak.

Despite the successes he and his team have had in defining bubbles, he admits there are problems with using their criteria as a tool to spot bubbles as they’re expanding. He claims that his approach results in calling a bubble on average 5 months before it actually peaks. While 5 months seems like a reasonable amount of time to do something, betting in either direction could be a risky move in itself.

Bubbles As Natural Part Of Market Cycle

Another way to approach the problem of bubbles is to view them as an inevitable part of a long-term market cycle. Sir John Templeton came up with a pithy take on the subject:

“Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” 

Jeff Saut, the Chief Investment Strategist at Raymond James, offered a more detailed description of the market cycle on minyanville.com in 2013, which I’ll quote and riff on here:

Stage 1: Shock and Fear. Investors are deeply demoralized and shun stocks. Rallies are shrugged off as fake recoveries, but eventually, bear markets make a more decisive breakout off lows.

Stage 2: Guarded Optimism. Market rallies are still viewed by many as a brief chance to sell and cut losses, but corporate earnings start to bring dividend seeking buyers back to stocks.

Stage 3: Enthusiasm. Templeton’s “mature optimism.” The economy actually starts to improve with the news backdrop going from bleak to better, which leads to greater enthusiasm, rising P/E multiples and prices.

Stage 4: Changing Attitudes. Confidence builds, memories of the previous bear market are vanquished, and investors are carried away by feelings that nothing can go wrong. The widely-held perception is that all stocks go up and all portfolio managers are geniuses. You also begin to hear stock tips from your barber, taxi driver, waiter, etc. on the hope that you will reciprocate. We start to see a lot of new IPOs and P/Es blow out of proportion to averages as expectations for growth sizzle.

Stage 5: Surrealistic Phase. Exuberance abounds. New stock offerings are of questionable value.  Stock valuations changing hands at “merely” 200x earnings. Stocks no longer bought on anything resembling fundamental analysis. Older financial advisors start to buckle under pressure to invest in “new paradigm” growth (aka bubble) stocks. Investors take on more leverage for speculation, businesses borrow via stocks and bonds and lines of credit, and consumer credit and spending soar.  Wall Street bankers and brokers revel in wealth and power.

Stage 6: Disillusionment. The Surrealistic Phase ends with the bursting of the stock market bubble. The economic outlook proves to be not nearly as positive as has been priced into stocks, ultra-high P/E ratio stocks are scorched first, then contagion spreads to blue chip and older stock names. Investors wrongly stay with losing positions, which actually could be sold at minimal losses, but investors cling to their losses when they should be jettisoned.

2017 Stock Market: Is It A Bubble?  Buffett Thinks Not

To bring us back to today’s market. Now I speak to the large number of you, many of whom I hear from every day, concerned about whether the 2017 stock market is in a bubble, I want to conclude with some recent comments by Warren Buffett on this topic.

Despite the fact that P/E ratios are undeniably high (17.7 times projected earnings, the highest since May 2004) and CNNMoney’s “Greed and Fear Index” has been flashing “extreme greed” in recent weeks, Buffet is convinced that stocks are still on the cheap side. The key, Buffett said, is that interest rates remain extremely low. That makes stocks look like a good deal by comparison.

“If interest rates were seven or eight percent, these (stock) prices would look exceptionally high”

– Warren Buffett

We’ll save explaining why he might be right on that point for another commentary, but suffice it to say that betting against Buffett is not something we’d ever do lightly.

So, I’ll continue to keep a wary eye on the whole situation; but, remember, predicting a bubble is not really possible, so don’t expect some bell to ring or the fat lady to sing announcing the end of the current bull market.

Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice.  Please contact your financial advisor with questions about your specific needs and circumstances.  There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. Equity investing involves market risk, including possible loss of principal.  All data quoted in this piece is for informational purposes only, and author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the data. All data are driven from publicly available information and has not been independently verified by the author.

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Steve Pomeranz
I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.