By: Andrew J. Willms
President and CEO of The Milwaukee Company
The ongoing stock market rally is about to celebrate its first birthday off the coronavirus bottom and it’s still going strong. U.S. stocks, however, are expensive, especially in comparison to the rest of the world.
The high prices investors are paying for stocks has led to many of my clients to ask: (i) are we in a market bubble, and if so (ii) when will it burst? Let’s consider both questions.
Is this a stock market bubble?
To answer that question, we must first consider what constitutes a market bubble. Unfortunately, there is no uniform definition.
If you interpret “bubble” to mean wild, unjustified speculation, then I don’t think we have entered bubble territory just yet. Yes, the volatility of stocks favored by the Robinhood crowd, surging initial public offerings, special purpose acquisition company (SPAC) mergers, and skyrocketing prices of Tesla (TSLA) and bitcoin are disconcerting. But the stock market is comprised of over 3,500 publicly trades securities, most of which have not blasted higher like a SpaceX rocket.
If, on the other hand, you regard a bubble as an elevated risk of loss if the markets change direction (that is, when the bubble bursts), then I think we might have entered Bubbleville. If not, it’s just a short trip from here to there.
In my view, the overall market has not yet entered bubble territory, but pockets appear to have done so. Clearly the prices of meme stocks like GameStop are unsustainable. The prices for the mega-cap FAANGs (Facebook, Apple, Amazon, Netflix and Google) might be unjustifiably high as well. But other sectors, such as health care, financials, industrials, utilities and energy stocks still appear fairly priced if not undervalued based on price-to earnings and price-to-book ratios.
When will the bubble burst?
As tough as it is to identify when a bubble has formed, it’s even harder to correctly predict when it will burst.
One of the drivers of the current bubble has been the massive and unprecedented amount of money the federal government has injected into the economy. If President Biden’s Save America plan is any indication, that spigot won’t be turned off anytime soon. The ink from his signature on the law has not even dried and already there is talk floating around the halls of Congress of a trillion-dollar infrastructure bill.
Another driver of the current rally has been the expectation that pent-up consumer demand will send corporate earnings soaring. This seems a reasonable assumption to me which, if correct, could push cyclical stocks higher.
Then again, stocks cost more now than they ever have before, if balance sheets are used to evaluate the prices being paid. If future expected earnings are used instead, then an argument can be made that stocks are considerably less expensive.
Another reason given for the market rally is the so-called “TINA trade”: interest rates are so low that There Is No Alternative. With the 10-year Treasury Note still paying well below 2% and the Fed not budging on its lower-rates-for-longer policy, I find this argument to be less convincing.
So what’s an investor to do? I don’t think we’ve reached the point where a major deviation from your long-term investment plan is warranted. In other words:
If you are an aggressive, long-term investor who prefers to overweight equities as a matter of course, there is ample justification for holding tight to your current plan.
If you have a long-term horizon but fear that a 10-20% drop in market prices would trigger thoughts of exiting the stock market, then I would look to rebalance and return the share of your portfolio invested in stocks to a percentage that is consistent with your long-term average. Another option; allocate a share of your portfolio to assets that are less correlated to stocks.
If you plan to begin withdrawing funds from your portfolio in the next two to three years, I’d give serious consideration to making those withdrawals now.
If you read this article in hopes of a simple answer as to what to do next, then I hate to burst your bubble. (Okay, I admit it -- that pun was a bust.) But market bubbles are a messy business that warrant thorough and careful analysis of your personal facts and circumstances. Let me know if I can be of help.
Thank you for reading.
Dan Dujmic, a Principal in Taxable Fixed Income at Piper Sandler & Co joined me for this week’s podcast. Dan and I talked about strategies for investing in the bond market in a rising rate environment. You can listen to the discussion HERE or on YouTube HERE.