Stock Market: Is It A Bubble If Everyone Sees It?

Long-running gains in U.S. stocks have some professionals using the “b” word again. But is the equity market really in or approaching a bubble?

A recent Bloomberg survey suggests many investors, analysts and traders think so. Dane Fulmer, an Arkansas-based trader, compared market conditions to an oncoming storm, saying, “You don’t have to be a weatherman to see clouds.” Meanwhile, usually bullish analysts have remained atypically cautious about the growth potential for stocks over the rest of 2014; though few are outright pessimistic, many are hesitant to predict much more growth, if any.

Is a bubble possible if everyone sees a bubble? While it is possible, it is not likely. Market psychology doesn’t usually work that way.

Bubbles generally occur when crowds convince themselves that the constraints or concerns of the past no longer apply. “This time is different” is an atmosphere in which bubbles inflate. Investors convince themselves that assets that have soared in value – be they tulips, or gold, or oil, or stocks – can only keep going up.

Consider the example of the dot-com bubble of the late 1990s. The initial success of many pioneering online businesses led to an overly broad sense of optimism, in which investors jumped on what turned out to be the top of stock prices’ crest in the firm belief that even companies without solid earnings and business plans would create massive returns. The Internet turned out to be a useful tool, but not, as The New York Times said in 2000, “an indiscriminate, magical new means of making money.” Yet because so many investors convinced themselves that their choices were rational, the cycle became self-perpetuating until the bubble ultimately burst. In a bubble, investors believe an asset’s value can only move one direction. They’re usually right – just not about which direction.

That atmosphere, however, is not what we are experiencing right now. While more expensive today than they have been in recent years, stocks are still not terribly pricy compared to companies’ earnings, which is what really matters. Many of the companies in the S&P 500 that have posted their earnings have beaten analysts’ estimates and exceeded sales projections, which gives optimism about stocks a reasonably solid foundation.

Perhaps more importantly, stock prices are not very expensive when compared to today’s extremely low interest rates. Those interest rates are themselves something of a bubble in the value of bonds, whose value increases as rates fall. So the inevitable rise in interest rates will most likely be bad news for stock prices eventually. But even a moderate rise in rates will leave bond yields at historically low levels – levels that, in the past, have not been a big hindrance to stocks.

The Federal Reserve recently agreed that, in general, investors “are not excessively optimistic regarding equities,” and that valuation measures were “generally at levels not far above their historical averages.” While the Fed’s biannual report did express concerns about certain sectors, specifically social media and biotech, it also mentioned low volatility; Bloomberg reported that the VIX, a measure of volatility, dropped to a seven-year low in early July. While some bystanders think the Fed’s certainty is unwarranted given its track record, there is real reason to think that corporate earnings, and not blind optimism, have underpinned the market’s rise.

As always, future stock prices depend on future corporate earnings or, more accurately, the expected future earnings of companies. If the outlook for economic growth, employment, wage growth, global trade, government finances and tax policy is reasonably favorable, stocks could continue to rise a lot higher than current levels.

That’s a big if, of course, not likely to be satisfied in all particulars, and possibly not in most of them. Certainly there will be another bear market at some point down the road; there always is. I am not making a prediction here about whether the current bull market has a long time to run. I can’t know with certainty whether or not it does, and neither can anyone else.

I am merely observing that a bubble, by definition, occurs when prices really only have one direction to go. Right now, stocks seem to be traveling on a two-lane road with very little objective evidence to serve as a signpost that we have entered bubble territory.

About Larry M. Elkin 551 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

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