Is The Stock Market In A Bubble?

Over the last few months, markets have set new highs, even if it doesn’t seem to make much sense. In talking with many people over the past few months, it seems that many intuitively and anecdotally agree with the idea that a “K-shaped recovery” has happened since the pandemic started a little over a year ago.

There’s been a recent proliferation of stories in the financial media questioning the market highs and wondering if an impending crash is on the horizon.

Is the stock market in a bubble?

First, we need to define “asset bubble“. A bubble happens when the price of an asset (stocks in this case) are bid up higher than the long-term sustainable value of the underlying assets would justify. Buyers continually bid up the price until, inevitably, the bubble bursts and prices return to reasonable levels.

So is the market in bubble territory? There’s no official measure or indicator that tells us definitively. However, there are a couple of markers that can give us the temperature in the room.

Market Valuations

First, we look at the “Buffett Indicator“: U.S. Market Cap (the value of the U.S. stock market) vs. U.S. GDP (the value of goods and services produced in the U.S.). Warren Buffett is purported to have said that this is the best (albeit imperfect) indicator of whether or not markets were overvalued. Often, people link this indicator to his famous quote, “Be fearful when others are greedy and greedy when others are fearful.”

Buffett Indicator

Graph source: Advisor Perspectives. U.S. market capitalization represented by the Wilshire 5000 index. U.S. GDP data taken from the St. Louis Federal Reserve FRED repository data.

If we examine the Buffett Indicator (as shown in the graph above), we can easily see that stocks are overvalued versus historical norms. In fact, the stock market, according to this measure, is more overvalued than during the Dot-Com Bubble and just prior to the Financial Crisis. That’s saying quite something.

There are others who argue that GDP, the denominator in this math equation, has been suppressed with COVID and expect things to normalize once the economy fully opens. That could indeed be the case. But as the old proverb goes, “There’s many a slip ‘twixt the cup and the lip.” Exogenous factors could negatively impact future GDP growth, assuming that simple growth is enough in the first place. Another strain of COVID, surprise inflation, or geopolitical turmoil could all interrupt an extrapolated recovery.

Margin Debt

Another measure of the current investing environment is the level of margin debt. Margin debt is simply money that people have borrowed in order to invest. Typically, the more margin debt that exists, the more “speculation” (a.k.a. gambling) exists in the markets.

Margin Debt Chart

Graph source: Advisor Perspectives. Values adjusted to today’s dollar using CPI data. Margin debt data taken from FINRA.

Adjusting for inflation, we can see (in the graph above) that margin debt has grown to an unprecedented level. It’s hard to say whether or not there was more speculation in the markets in the 1920s, but there is certainly more than we’ve seen in the digital age.

Also, note the steep acceleration in margin debt over the last 6 months. Where else do we see this on the above graph? You guessed it: 2000 and 2007.

The confluence of working-from-home, low interest rates, stimulus, and easy access to trading platforms (such as Robinhood), have contributed to the resurrection of day-trader culture, reminiscent of the Dot-Com era or even the late 1920s.

Like Water Off A Duck's Back

Cartoon circa 1929, Columbus (OH) Dispatch.

Is The Stock Market In A Bubble?

What does all this mean? The combination of extremely high market valuations combined with record levels of speculation is cause for concern.

There’s a good case to be made that the market is a bit bubblicious at the moment.

More often than not, asset bubbles go on for much longer than anyone expects, assuming that’s what we are experiencing right now. Indeed, GDP growth may bring valuations back down from geosynchronous orbit. Many in the financial press point to pent-up demand and expected GDP growth as a case for markets going higher. They may be right.

Although we can never predict the timing, there is one aspect of investing in which we can be certain: there will always be corrections in the future. By nature, bubbles pop. However, it’s only in hindsight that the picture is clear and everything seems obvious.

If you’re concerned about how a stock market drop could affect your investments, click here to schedule a quick call. I’m happy to talk with you about how to prepare.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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