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Why We Are NOT in a Market Bubble

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Steve Pomeranz, CFP

Markets Are Hitting New Highs…

This week, the S&P 500 Index – which is a broad-based index of the 500 largest U.S. companies – set a new record high of close to 2,130… and the technology-oriented Nasdaq is also near a new high of about 5,087 – above where it was at the height of the dot-com boom in March 2000… except, of course, this time around it’s taken 15 years to scale that 5,000 level. But with markets up strongly since they bottomed around March 2009 – many are beginning to wonder if we are now in a bubble… or whether valuations are justified relative to everything else such as ultra-low yields on bonds, uncertainty in emerging markets, instability in the Euro zone, terrorism and its impact on crude oil prices, etc. In other words, are U.S. stock valuations justified because they seem to be the perfect safe haven given the rising strength of the U.S. economy and its relative attractiveness vis-à-vis other global investment options.

So I dug a little deeper on this and came across an article on CNBC on Ray Dalio’s view of the market. Ray founded Bridgewater Associates – the largest hedge fund in the world with $169 billion in assets under management for institutional clients like pensions and endowments – and he’s personally worth over $14 billion… so his economic views are widely followed and respected.

This Is Not a Bubble… Here’s Why:

In the article, Ray says “this is not a bubble”… so, curious to know more, I read on, and here’s what I make of Ray’s reasoning.

asset prices are on the high side… so investors should expect the market to deliver low positive returns, not the high gains we saw over the past few years

First off, he makes a valid point… he says asset prices are on the high side… so investors should not expect outsize returns off already high levels but should expect low returns on passive investments such as index funds – so expect the market to deliver low positive returns but don’t expect the market to rise at the same rate as it has over the past few years.

That said, the analysts at Bridgewater do not believe we are in a bubble right now and here’s why. They believe stock prices have indeed increased quickly since March 2009, but not as fast as other bubbles – it’s been a gradually steady rise with mid-course corrections, and nowhere near the spire-like sharp rise we saw over the short-span of the dot-com boom. They believe stock valuations are still in “normal territory” and the rise has not been fueled by excessive borrowing of cheap money to bid-up the market… so leverage isn’t a major driving force of prices and overall lending is still “modest”. In addition, there aren’t any significant new investors entering the market and both U.S. retail and foreign investors have “modest” positions – in line with historical ratios… so it’s not like there’s a lot of disproportionate capital flowing in that’s taking asset values way past reasonable valuations.

Other Signs Also Point to Normalcy

Another sign that the market is not over-valued… Corporate Stock Buybacks – there’s still a healthy level of Share Repurchase Authorizations at most U.S. companies, which is another signal that management believes shares are reasonably valued and worth buying back at current levels. See – when prices spike too much, Corporate Boards often curtail buyback activity because they don’t think it’s the best use of corporate capital… but since we are seeing reasonably healthy buybacks, Bridgewater says that’s another data point that suggests stocks are not over-valued.

And finally, economic sentiment is “less ebullient” than other bubble periods – investors have been chastened by the crash and Great Recession of 2008 and our economy, as well as major global economies are still struggling – to varying degrees – to rev up their economic engines.

In short, Bridgewater doesn’t think the situation today is analogous to the Roaring ’20s, the dotcom boom of the late 1990s or the housing-fueled bubble of the mid-to-late-2000s.

Frothiness Could Lead to Short-Term Corrections

That said, they do see frothy bullish sentiment and pockets of froth in high-yield bonds and commercial real estate. But even those aren’t of a magnitude that amount to a bubble. And remember this, we may not be in a bubble, but the froth that Bridgewater talks about can cause short-term corrections, such as a 5% or 10% dip if the bulls get too carried away – which is a normal part of the investment cycle… so we could see selective corrections of shares that get carried too high by extreme bulls but correct when they fail to deliver to over-inflated expectations – and we saw that in the recent Q1 earnings cycle where companies such as LinkedIn got pummeled – down 25% – after they announced Q1 results.

So assets not being in a bubble doesn’t mean they can’t decline and aren’t vulnerable to surprises, but it does make an across-the-board cascading pop in asset prices much less likely.

While Bridgewater doesn’t think there’s a bubble, Dalio believes the U.S. is in a long-term period of slower growth – so-called secular stagnation. He believes that after lowering rates to rock bottom and engaging in massive bond-buying stimulus programs, the Federal Reserve and other central banks now only have limited policy tools that they can use to boost the economy. That means less lending, and therefore less investment, and lower economic growth. So in this tepid economic environment, Bridgewater is avoiding “any concentrated bets” – and I’d advise my listeners to do the same… in other words, look at your portfolio and see if you can spot pockets of froth, then consider exiting or hedging some of your frothy positions and moving into more reasonably-valued assets… this may be a good time to take your huge winners off the race, perhaps add to your cash position to take advantage of minor corrections… and consider staying invested in equities for the most part so you can continue to benefit from small but positive returns – more than what you’d get in cash, CDs or bonds. This may also be a good time to talk to your investment advisor about selectively hedging some of your big winners, to keep the upside but protect on the downside.

SOURCESCNBC
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.