Are We In A Stock Market Bubble?
By: Brian Seay, CFA
Are we in a stock market bubble? The market certainly “feels” overvalued relative to our experiences in the economy day in and day out. The phrase "stock market bubble" is in the media a lot and many of our clients and friends have asked me the magic question – are we in a stock market bubble? Is this irrational exuberance or is it rational growth? So on this episode we will talk about where things stand relative to past bubbles, and I’ll answer the questions no one seems to want to answer on the record – are we in a bubble?
Transcript:
Hello and Welcome to the Capital Stewards Podcast. The phrase "stock market bubble" is in the media a lot and many of our clients and friends have asked the magic question – are we in a stock market bubble? Is this irrational exuberance or is it rational growth? So on this episode we will talk about where things stand relative to past bubbles and I’ll answer the questions no one seems to want to answer on the record – are we in a bubble? Lets dive in.
Before we dive it to today’s history lesson, we need to talk about the tools we use assess stock market valuation. How much is to much to pay for a stock? When is it overvalued. The simplest form of valuation is called a market multiple. We look at the price we pay for a particular share of in a company vs. that companies earnings. That’s called the P/E – or price earnings ratio. If a stock – or stock index – has a PE ratio of 10, that means we are paying 10 times the earnings of the company or companies to own the stock. Another way to think about it is that we would need 10 years of current earnings to recoup our investment. We will talk about market ratios as we go through this episode but just keep in mind- when I say PE ratio – that’s what I mean – the ratio of a stocks price to its earnings.
In order to know if we’re in a bubble now, we need some reference point for prior excesses. There have been 2 stock market bubbles and subsequent crashes in modern history, the 1929 crash that led to the Great Depression and the tech bubble that burst in 2000 and led to an early 2000’s recession.
At the beginning of the 1920s, the average stock traded for about 10 times its earnings, so a PE ratio of 10. By the beginning of 1929, stocks were trading at more than 20x their earnings. Not only had the earnings of the companies grown as the U.S. economy grew during the roaring 20s, but the price investors paid for a unit of earnings doubled over the decade. Then, from the beginning of 1929 to the Crash in September, the average valuation moved up another 10x to almost 32 times earnings before the crash. Part of the speculative excess at the end of the party in 1929 was driven by the invention of margin, which allowed investors to borrow money to buy stocks for the first time. That magnifies returns on the way up and on the way down, contributing to the bust that sparked the Great Depression. Notably, there wasn’t a specific event – like a company earnings miss or bad set of economic data – that triggered the Crash on Black Thursday in 1929. Sentiment among some prominent investors shifted, investors began selling, and since the market was built on so much leverage, the whole market collapsed as investors that invested borrowed money were forced to sell to repay their debt.
In the1990s a new wave of technology raised optimism that personal computers and the internet would revolutionize the economy and the companies that were behind that revolution stood to benefit. By the mid 1990s, investors began buying up internet and tech stocks at a frenzied pace. A great example was Webvan, which promised Amazon like home delivery services for a myriad of products. The problem was that Webvan was ahead of its time and it never actually turned a profit. Not $100 Million, not $1 Million, Webvan lost money every year it existed. That didn’t stop investors from piling into its IPO, which valued a company with zero profits at $4.8 billion. Investors didn’t stop there, the stock rose to a total market cap of $8.8 billion before eventually going bankrupt because it never actually made any money. There a lots of other examples of companies from the late 1990s where investors simply didn’t do diligence on the business prior to investing. The broad market S&P 500 started off the 1990s at about 15 times earnings, rising to 25x before the bubble burst in 1999. Like the 1929 crash, there was no one event that cause investors to sell. The Fed raised rates starting in 1999 to combat inflation that was picking up as a result of the asset bubble. Investors began to look more closely at the results of the .com companies and as profits failed to materialize, investors began selling shares. Like in 1929, investors used margin loans to buy stocks on the way up and that made the crash worse on the way down as investors were forced to sell to repay their debt.
So what does history tell us about Bubbles? First, in both instances, you saw a significant valuation increase (1/3rd of the market or more) in a short period of time, indicative of speculative excess because company performance doesn’t generally improve that much that quickly. Second, you see a loss of rationality. Investors piling in blindly instead of doing their homework on the value of the underlying companies. Third, its very difficult to know when the “irrational exuberance” will stop. Neither modern bubble had a major event that cause sentiment to change. It simply changed, and changed very quickly.
So lets look at where we stand today and compare our current situation to history. History doesn’t repeat itself – but it usually rhymes so I think its instructive here.
Lets start with the valuation of the stock market. Is it expensive or fairly valued? One good way to measure long term valuation is called the CAPE Ratio. Remember that PE ratio we discussed earlier? The Shiller CAPE ratio is based on PE ratios, but it smooths out the normal business cycle variability we see over time. So it’s a good way to build a longer term view on market valuation. You can see in the chart, the CAPE ratio right now is about 37. That’s certainly high, but its just now in-line with the ratio we saw in 2021 around 37. During the Tech bubble, the CAPE ratio peaked at 44, so certainly elevated, but we still have some room to run based on prior market bubbles.
We talked about PE ratios earlier. Currently the S&P 500 trades at 22x next year’s earnings. The 10 year average is closer to 18x. The peak in the tech bubble was around 25 times earnings. 22 may sound close to 25, but to get to multiple of 25 times earnings, the market would need to rise above 7500 from 6800 today, that’s another 17% increase – and of course earnings would need to be in-line with consensus around 303/per share for the S&P 500 next year. So on a PE basis, the market is certainly not cheap – which would be below 18x earnings – but its also not as expensive as it was in 2000.
When we compare history, it’s also worth looking at the pace of the increase in the market. Both of our recent historical examples saw significant run ups in valuation over a year or less. That means the market move significantly higher without corresponding earnings to support the speculation. We haven’t really seen that in this market yet. The market last bottomed at 18 times earnings at the end of 2022. Since then, over the last 2 years, the market multiple has only expanded by 4x from 18 to 22. If we were tracking something like the 1929 Crash or the 2000s tech bubble we would expect the market to be over 24 times earnings already and moving higher. So the pace, while it has felt fast, has been more orderly than some historical run-ups. That slower pace allows companies to improve their underlying business performance to keep up with the market. We we look outside PE to other valuation metrics, like Price to Book or Price to Cash Flow ratios, we draw similar conclusions. The market is not cheap, its likely “overvalued,” but its not at extreme levels.
I think its also important to look at what’s happening in the real world of the companies that investors are buying shares in. Let’s look at NVIDIA, which has been the poster child of the run-up in valuation in this cycle. Yes Nvidia’s stock price is up a lot, and its multiple has increased as well, but that’s not without real underlying company performance. Nvidia’s net income has moved up from around $4B at the end of 2022 to now tracking at over $70B per year. That’s a massive increase in real profits generated by the company. Alphabet – better known to many as Google – has seen Net Income move from $75 Billion annually to north of $115 Billion. Meta – or Facebook – or even better Instagram – their Net Income has gone from about $40Billion to $70 Billion annually. So there has been real growth associated with the increase in the valuation of many of the tech companies driving this rally. Its also worth noting that – unlike in the 2000s tech bubble – these companies are generating real cash flows and profits. These companies are generating tens of billions of dollars in profits in each quarter. There aren’t any “webvans” in this rally.
One of the other things we saw in historical bubbles was the excessive use of margin to help investors buy more stock than they could otherwise afford. Margin usage has been in the news lately. FINRA, which is one of the regulatory bodies responsible for the investing industry announced that outstanding margin debt reached all time highs in July of this year. However, I think its important to evaluate aggregate balances in-line with the size of the economy. For example, the total amount of consumer debt hits a new high almost every single year. Does that mean consumers are over leveraged? Not necessarily, the economy is growing and there are more consumers making more money. What really matters is the size of their debt relative to their income. That’s a much better indicator of how well consumers are doing than just an aggregate debt level. So margin debt is now over $1 Trillion dollars. However, its only just over 3% of GDP. We saw margin debt levels above 3% of GDP in 2017, when there was no crash. We also saw margin debt touch 3% of GDP in the late 1990s before the tech bubble. So while the level of margin debt is concerning, I don’t think it alone is an indicator that the market is over extended. However, margin debt as a percentage of GDP is up almost a full percentage point over the past 2 years. Given the rapid rise and the level, I do think it’s a “Yellow Light” and worth watching because if we do get a market draw down, I think margin debt is high enough to accelerate the downward move in stocks as investors are forced to sell.
Alongside margin debt, I think two other issues related to market structure are worth watching for investors. The use of options, especially by retail investors, has expanded significantly over the past decade. Options has inherent leverage and so when the market turns and the options activity drys up, the move down may be exaggerated. The same is true with leveraged ETFs. Many investors are effectively using leverage by owning ETFs like the Tripled Leveraged NASDAQ ETF that employs leverage. So I think there is more leverage in the market than we really even understand – all of that is big flashing yellow light for a potential downward correction.
Lastly, in all of our historical examples, attempting to predict whether we were in a bubble was difficult to do because investor sentiment shifted suddenly, almost inexplicably. That means investors need to be disciplined and not chase the market on the upside. Your portfolio should include some of those high growth stocks that have done so well, but you should also own other slower growing assets like bonds and gold that will do ok most years and really well if the stock market does move significantly lower. Staying disciplined and sticking with your asset allocation and investment program overtime has a much higher likelihood of success than trying to call market tops and bottoms.
If we sum it all up, I think the market is expensive on a valuation basis. Anyone that isn’t actively thinking about the market’s high valuation needs to come out from under their rock and put on their glasses. But, I think we’re in more of a yellow light type moment than an eminent bubble. There is real underlying business momentum from the companies who’s stock prices have increased the most – meaning those upward movements – even if slightly exaggerated – are more or less deserved. The margin debt, options and leveraged ETF strategy is also a yellow light. Not a concern for now – but something that could become concerning if the economy turns. In short, I don’t think valuation or the structure of the market will become a problem for investors short of a recession. If we have a recession, then the conditions are ripe for a significant correction. Despite the bad labor market data from the summer, the early indication on the economy for August is that activity is picking up in August after a slowdown in June and July. The key watch item is consumer and the labor market – that will tell the story of the economy. If we don’t fall into a recession, which is my current expectation, then the market can continue grinding ever higher. Regardless of the market outcome, if you are investing in a disciplined, diversified way, you should be comfortable regardless of the outcome.
Thanks for tuning in to this episode of the Capital Stewards Podcast and we will see you next time.