Evidence points to market not being in a bubble
With stock prices continuing to ramp higher, some commentators have raised the possibility that a broad market bubble might be forming.
Certainly, stock market valuations are high by historical standards and there have been bouts of crazy trading in cryptocurrencies and certain stocks like GameStop. So some bubble indicators are present.
But I side with the contrary viewpoint. At this point, I don’t think we’re in bubble territory for the stock market as a whole. I think market valuations for many stocks outside of speculative pockets can still be justified as reasonable given today’s exceptionally low interest rates. Thus the key bubble indicator of market-wide irrational buying behaviour appears to be missing.
Of course, overall market bubbles are notoriously difficult to identify correctly except in hindsight after they burst or don’t burst, so I could be wrong. And, whether there is a post-bubble market collapse in the offing or not, stock markets always carry the risk of a fairly substantial sell-off that might be lurking just around the corner. You still need to be careful about risk, regardless.
Here’s my view on what you should do in this situation, which is based on pretty standard advice from experts (and may be obvious to many seasoned investors). For starters, avoid bitcoin and speculative stocks like GameStop that have been caught up in socialmedia-driven trading frenzies. (Or if you must, at least limit your exposure to a small position you can afford to lose.)
If you’re investing for the long run, you should generally stay invested in a balanced portfolio of stocks and fixed income that follows your long-run asset allocation based on your objectives, risk tolerance, time horizon and other individual factors.
As stock prices rise, you should gradually rebalance to maintain your target asset allocation, which in this specific situation means selling stocks and buying fixed income (and thus curtailing your stock exposure).
That classic advice applies whether markets are at a high valuation or not. “Regardless of what’s happening around you, the advice doesn’t really change because these are bread-andbutter basics,” says Dan Hallett, vicepresident of research at HighView Financial Group, an investment counsel firm.
It’s important to appreciate that getting out of stocks because you fear a bubble comes with different risks. Stocks could end up earning attractive returns for years, which you would then miss out on. Once you bail on stocks, it’s hard psychologically to buy back in. Trying to time the market with reliable success is really difficult or impossible, even for professionals.
While stock valuations as a whole are high by historical standards, valuations on many stocks can be justified in today’s ultralow interest rate environment.
Understand that current lofty market prices provide a high starting point that makes relatively low stock returns likely in the future. Based on that relationship, the stock market is pricing in annual expected returns of roughly four to eight per cent, says Paul Moroz, chief investment officer at Mawer Investment Management Ltd., a Canadian investment firm that invests globally.
But with low inflation and low-risk alternatives like government bonds earning negligible yields, “then the real return (on stocks) actually doesn’t look so bad,” Moroz says. Thus there are rational reasons why investors might view current stock prices as acceptable, which in turn helps sustain those prices.
Some commentators in the bubble camp see parallels between current conditions and the tech growth stock bubble of the late 1990s, which burst in 2000. Value stocks performed as the mirror opposite during that period, lagging dramatically during the tech boom and then thriving in the early 2000s after the tech stock collapse.
But Moroz says now you should assess stock valuations individually rather than make sweeping generalizations about tech stocks, growth stocks or value stocks. “The press and (much of ) the financial community is still focused on this value versus growth thing — we’re using lexicon from a prior period.”
He says some tech stocks are reasonably valued under current conditions and others aren’t. Tech stocks often come with high valuations in terms of price-earnings ratios and other metrics, but many are highly scalable businesses that are able to generate fat margins with strong growth that compounds dramatically, thus sometimes justifying the high valuations, he says.
Mawer tech holdings in different funds range from small firms like Elastic N.V. (an American-Dutch search technology company) to dominant tech behemoths like Google, Amazon and Microsoft. On the other hand, Tesla is an example of a tech company Mawer doesn’t own and that “seems to be more speculative.” He says it “doesn’t make a lot of sense” that Tesla’s stock price is up more than 10 times in less than a year from a March low point.
Moroz distinguishes four noteworthy categories of stocks, each beginning with the letter “S.” These are: “scalable” (which includes many tech stocks); “stranded” (where valuations have lagged the market and which includes many value stocks); “stable” (examples include consumer staples companies like Procter & Gamble); and “speculative” (which includes stocks caught up in recent trading frenzies, like GameStop).
“You can find pockets of reasonable valuation in each of those first three S’s and you have to avoid the last one,” he says. Even more importantly, diversifying by different types of stocks outside the speculative category helps to spread risks, he says.
“My advice for most people is don’t try to think you know the market is overvalued or undervalued or there’s a spot of value here or there,” Moroz says. “We’re trying to shift the odds of the portfolio to do that. But what our (overriding) goal is just being balanced, just being resilient.”
While today’s high stock valuations shouldn’t deter long-term investors from sticking with their long-run asset allocation, you should nonetheless temper future expectations. Here are three parting points: á Firstly, high stock valuations increase the odds of encountering a major stock market correction at some point. “The higher the valuation, the higher the risk, the higher the sensitivity to any bad news,” says Hallett.
á Secondly, don’t count on high stock market returns in the next few years. “The message — that asset prices are very high means that future returns are expected to be low — is one that I think people need to hear,” says Hallett. á Thirdly, be prepared for a wide range of possible investment outcomes. “In this environment, we have ultimate uncertainty and you have to look at the world probabilistically,” says Moroz. “How many people would have thought on the onset of a global pandemic that this turns into a roaring bull market? You have to keep your mind open to different possibilities about how the world turns out.”
David Aston, a freelance contributing columnist for the Star, is a personal finance and investment journalist. He has a chartered financial analyst designation and is a chartered professional accountant. He is author of the “Sleep-Easy Retirement Guide.” Reach him via email: davidastonstar@gmail.com.