Many people are now saying that the stock market has reached the status of a bubble and many of your clients may now be saying this too. With stocks reaching new highs and corporate earnings stagnating at the same time, the time may seem ripe for this “bubble” to burst, leaving stocks at a much lower level and more in line with their current earnings.
But this talk of a bubble is probably a bit overblown. When your clients tell you that the market is in a bubble, you may be best off simply telling them that they most likely don’t have a clear picture of the real definition of that term.
One of the problems that you may have in convincing your clients that the market is not in a true bubble is the media, where Donald Trump recently stated that the stock market is “all a big bubble.” And CNBC aired a headline back in June that asked, “Uh oh. Is the stock market a bubble again?” (For more, see: How to Talk Your Clients Through Bad Markets.)
A True Bubble
However, the academic definition of a true market bubble is somewhat different than what most people mean when they say this. Jeremy Siegel, Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, stated that the term has been loosely and incorrectly used in many instances. “It used to be reserved for something way, way overvalued," he told Investment News. "Now anyone who thinks a market is overvalued says it's a bubble. A good rule of thumb is that something should be 100% or 200% above its fundamental value before it's a bubble.”
Of course, the market is most certainly trading above its fundamental value at the moment. The Standard & Poor’s 500 Index trading at just over 18 times its earnings, which is above its historical average. But that may not be as overvalued as some think, given the current level of interest rates. When the tech bubble burst back in 2000, the S&P was trading at 30 times its current earnings. Furthermore, many of the hot tech stocks at that time had absolutely no earnings at all, and interest rates were much higher than they are now. (For more, see: How Advisors Can Prepare for a Bear Market .)
Market bubbles are always easy to see in hindsight, but they are very difficult to predict beforehand because there is a reason why stocks are trading at the levels that they do before the bubble bursts. Many experts claimed that they saw the tech and housing bubbles burst before they did, but only a handful genuinely predicted that this would happen when it did.
True bubbles are fairly rare and they are almost inevitably accompanied by a substantial expansion of credit. Bubbles can happen in the market of any commodity, and even experts and wealthy investors can get caught up in them (just like those who lost everything in the tech bubble). Both George Washington and Isaac Newton lost money pursuing investments of their time that came up snake eyes. It is more likely at this point that we will see a bubble burst in the bond market before the stock market at this point, although the markets may experience a correction.
The Bottom Line
When your clients tell you that the market is turning into a bubble, explain to them the true meaning of this term and show them the differences between the current market and the state of the markets during the last two bubbles. This can help put their minds at ease over where stocks are now. Earnings will have to rise or stocks will have to fall before their fundamental relationship is restored, but we are not in true bubble territory at this point. (For more, see: Tips on How Financial Advisors Can Talk to Clients.)