We’ve been here before. We are currently in the later stages of witnessing a stock market bubble inflate but, as usual, it appears that it will inflate forever, leading investors to fear of missing out (FOMO). Even a pandemic could not burst this bubble, although it tried.
In the 1960s it was the Nifty 50; today we have the FAANGs. In the 1990s it was “Trees can grow to the sky.” Today it’s “Don’t fight the Fed.” In 2008, it was a different bubble—housing prices were the bubble. Another parallel: The Roaring Twenties set the stage for the Great Depression, which began in 1929 and lasted a decade that was marked by a dozen “W” crashes and recoveries. The Roaring 2010s may have set the stage for the next great depression.
There are plenty of reasons to be Bulls or Bears, but beware the Pigs. As we recently discussed, the stock market will reconnect with the economy—it always does. The likely reconnection is a bursting of a stock market bubble that was already highly inflated even before the pandemic struck.
Here’s the bubble
According to Wikipedia, a stock market bubble occurs when “market participants drive stock prices above their value in relation to some system of stock valuation.” Of course, the “some system of stock valuation” is subject to interpretation and judgement. We discuss two such systems here.
Price/earnings ratio is one system for estimating expensiveness. The historically “fair” price for one dollar of earnings has been about $16—the average P/E ratio is 16. In the past when P/Es have risen to multiples of the average, stock markets have subsequently crashed. As shown in the following, the U.S. stock market is currently priced 35 times earnings, more than twice the average P/E.
Figure 1: Expensive Stock Market
Source: Ron Surz
Looking to the far right of the graph above, we see that the growth bubble burst in 2000, then recovered only to be slammed by the housing bubble of 2008. And then the 2010s drove up multiples to 35 coming into the decade of the 2020s. Optimists explain that current multiples are justified by the huge success of the FAANG stocks—Facebook, Apple, Amazon, Netflix and Google. These stocks were thriving in the 2010s and got a big boost recently with the pandemic. They currently comprise 23% of the S&P 500’s total capitalization.
We’re being told that the “valuation system” for these FAANG stocks is the “sky that trees grow to” we had in the 1990s growth bubble. Apple is a prime example, having just reached a market value of $2 trillion. As shown in Figure 2 below, if Apple were a stock market it would be the seventh largest market in the world, on a par with the stock market of Canada. Do you think this a “fair” price? Why?
Figure 2: Apple—7th Largest Country, Tied With Canada
Source: Ron Surz
Warren Buffet has popularized another valuation system. When the value of the U.S. stock market exceeds GDP, it is expensive. This measure has successfully signaled market crashes in the past…and currently stands at a 180% all-time high. The average ratio is 80%, so we’re currently more than twice average.
Figure 3: Buffet’s Expensive Market Rule
Source: Ron Surz
The pandemic couldn’t burst the bubble
Even though Covid-19 was first identified in December 2019, it was not recognized as a pandemic until February 2020, at which time the U.S. stock market proceeded to drop more than 30% through mid-March. But then, remarkably, it recovered even though corporate earnings remain in the dumps.
Figure 4: S&P 500 Recovers Expensive Price Level While Earnings Plummet
Source: Ron Surz
The U.S. stock market has recovered from Covid even though the economy is suffering.
The disconnect with the economy
The U.S. economy is officially in a recession, defined as a decrease in GDP of 10% or more:
Figure 5: Real GDP—Percent Change From Preceding Quarter
Source: Ron Surz
And unemployment is at 10%, having improved from an initial peak of 15%. For contrast, unemployment in the Great Depression peaked at 25%.
Figure 6: Unemployment Down From Peak
Source: Ron Surz
Bursting bubbles
At first observers believed that Covid would be the match that lit the market’s overvaluation tinder, but they were wrong, at least so far. But the pandemic is not yet over, and its repercussions will be felt for years after a vaccine is found. It’s not going away. In the meantime, other threats could easily create a market crash, and some have intensified like trade wars with China. These threats (discussed in this video) are summarized as follows: Covid-19, stock and bond market bubbles, per capita world debt at $200,000, threats from North Korea and Japan, the possibilites of hyperinflation and threats to Social Security and Medicare.
Summary
The U.S. stock market bubble is inflating. The more it inflates, the bigger the consequent pop. We’ve been here before, prompting recommendations like “Stay the course” and “Buy the dip.” This advice can work for investors with long horizons.
Stock markets usually recover fairly quickly from crashes, but it took a decade to recover from the crash of 1929. Importantly, our 78 million baby boomers might not recover from the next stock market crash because they are in the risk zone spanning the five years before and after retirement, when investment losses can dramatically curtail lifestyles in retirement.