Hardly a day goes by where someone isn’t asking me if I think the stock market is a good place to have their money. Those who know me know that I am a big proponent for stock ownership. But as with anything, you don’t want to overpay when you buy something, including stocks. To be straight up, yes, I think the stock market is in a bubble. Furthermore, I think we are setting up for a good sized drop at some point in the not-to-distant future.
Now before you go sell everything and run for the hills, I want to remind you of an old saying by John Maynard Keynes, the famed economist who wrote the main theories governing our economic system today. He said “The market can remain irrational longer than you can remain solvent”. So just because the market is overpriced, that doesn’t mean it can’t become more overpriced. And if it becomes under-priced, that doesn’t mean it can’t go lower.
Evidence of a Bubble
One of the oldest indicators of market valuation is the price-to-earnings (P/E) ratio. Looking at a stock, or basket of stocks such as the S&P 500, you divide the price of the stock by the earnings of the stock. In other words, if you were going to buy this stream of earnings, what would you pay for it? Traditionally, the S&P 500 has been priced around 11 to 15 times earnings. If earnings were $1 annually, you would pay $11 to $15 for that earnings stream. Lately, the S&P 500 has been trading around 25 times earnings, so people have been willing to pay twice the historical average. Market corrections (i.e. selloffs) become more prevalent as the P/E ratio moves up to 20. We are above that now. The largest market drops in history hit when the S&P 500 P/E was around 30. So the market is very expensive here.
Another traditional indicator is volume. Volume is the number of shares traded for a particular stock, or basket of stocks, over some period of time. I like to look at the monthly volume for the S&P 500. Over the past few years into the current bull market, volume has been decreasing, which means that the market is rising on fewer and fewer trades. There is only one thing that causes stocks to rise, and that is that new buyers are willing to pay more for the same stock than the old buyer did. If there are fewer of those buyers out there, there is less pressure for stocks to be able to move higher.
The appearance of a healthy stock market happens when the news reports the DOW Industrial Average (a 30-stock average) or the S&P 500 average rises. The problem with these headlines is that these are the largest companies in America, and not the market as a whole. When money doesn’t feel safe, it tends to move from small risky stocks to the larger stocks, perceived to be be less risky. Therefore, the market can have underlying weakness, while the news headlines report on ever-rising stock indexes.
A lessor-known index is the Russell 2000, an index made up of many smaller companies. After the “Trump Bump” in November/December 2016, this index has hardly moved, especially when compared to the Dow or S&P 500. This implies that the little bit of new money coming into the market is going almost entirely to the big names, and in particular the “FANG” stocks (Facebook, Amazon, Netflix, and Google). Indeed, these stocks are trading at P/E ratios far in excess of what many market watchers consider “healthy”. So when a downturn takes hold, these stocks will likely be some of the biggest losers.
My Indicators and Investment Direction
I have a set of indicators I use to gauge when the market is turning a corner. These have been developed over 20 years, and have been back-tested for over 100 years. They seem to work well when it comes to longer term stock market valuation changes. So far, my indicators still point to a higher market. Again, just because the market is overvalued doesn’t mean it can’t become more overvalued!
So while I am rightfully nervous, I am staying the course for now…..leaving long-term funds like 401k money in the market. If I see a change in the indicators, I will sell in a heartbeat, moving those funds to a money market fund. I am not allocating new non-401k money to stocks however, except to high-dividend stocks. I am buying gold, both the hard metal, and the exchange traded fund (GLD). In the event of a market sell off, I believe gold will rise…..at least initially.
Where Else to Put Money?
There are only a few options if you have money to invest. The first is stocks, which appear overpriced here. The second is bonds, where are also very overpriced. As interest rates go lower, bond prices move higher. Interest rates are at record lows, which means bond prices are at record highs. Bill Gross, who co-founded PIMCO, one of the largest investment companies in America, has been warning of a major bond correction for some time now. Again, the market can remain irrational longer than you can remain solvent. So I don’t look to stocks or bonds for an ideal place to have money.
Another place to keep money is in commodities. These are things like gold, or oil. When market crises hit, everyone runs to gold. They also may run to oil. Oil has seen significant declines over the past few years, and I like buying it on dips because it is historically priced below average. I have already mentioned that I like gold, particularly at the early stages of a market sell off. And if we don’t see a big market sell off, gold will likely hold value due to inflation.
Real estate is another commodity, but its valuation will depend on location more than anything. Some markets are under priced and have not taken part in the recovery, while some are again overpriced. Before investing, ensure you know which side of that spectrum you are on.
There are also “derivative” types of instruments professionals invest in. These include options, futures, or short positions in the market. These are not positions that really own anything except rights. They are trades in “risk”, and are not advised for a novice.
The final place to have money is in cash (or money markets). You will likely never lose here. But you will also gain very very little. But if everything is going down, this is not a bad choice.
While I cannot say when the market will turn down, I feel comfortable in my evidence that we are in a stock market bubble. I believe there are significant risks in the economy that will make the next downturn significantly worse than a typical downturn. Debt is very high among all economic players, be it individuals, corporations, or governments. I don’t think the Federal government will have the will power or resources to save the economy like the last time if things get bad. Because of debt, I believe defaults will be very high yet again.
As a result, I am playing it safe, and keeping a close watch on things. Nobody ever lost playing it safe. But they may have lost opportunity if they were wrong.