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Popping Bubbles

Jonathan Clements

Director of Financial Education

Last Updated
January 20, 2021

I have no clue what will happen next to stock prices.

Others seem far more certain. Words like “speculation,” “bubble” and “irrational” are getting tossed around, including by people whose opinion I respect. But I’m not making any significant portfolio changes. Why not? Here are seven reasons:

  1. The stock market isn’t as expensive as it appears. Last year’s economic contraction hammered corporate earnings, which likely plunged 32% in 2020. As the reported profits of the S&P 500 companies have shrunk, the stock market’s price-earnings ratio—probably the most popular market yardstick—has soared to 38, well above the 30-year average of 25 times earnings. But what if we look ahead? Based on estimates for as-reported earnings from S&P Dow Jones Indices, the S&P 500 stocks are currently trading at 25 times 2021’s corporate profits, right in line with the 30-year average.
  2. Beware anecdotal evidence. It’s often said that stories are more powerful than statistics. Most of us don’t live next to nerdy money managers who build well-diversified portfolios. Instead, we live next to everyday investors, a few of whom may be doing crazy things in their Robinhood account. When we hear their stories, it’s easy for us to imagine such foolish behavior is widespread.
    • Similarly, national newspapers don’t call up money managers, seeking stories of misguided, overconfident investors. Instead, the media highlights loopy individuals who have bet everything on Tesla—and such anecdotal information can heavily influence our view of the financial markets. But guess what? The big holders of Tesla’s stock are large institutional investors like Capital World Investors, Baillie Gifford and Fidelity Investments. Are they also loopy? In fact, professional investors likely account for well over 90% of all U.S. stock trading. The behavior of a few amateur day traders is immaterial.
  1. All the hoopla over Tesla, SPACs (special purpose acquisition companies), leveraged exchange-traded funds and cryptocurrencies is unnerving. But who says you have to own these investments? There are plenty of other investments to choose from. As it happens, I do hold Tesla’s stock, because it’s in some of the index funds I own. But if it comes crashing back to earth, it won’t put a big dent in my portfolio’s performance. What if it keeps soaring? You’ll find me boasting about my investment savvy at next summer’s neighborhood barbecue.
  2. Bubble? What bubble? Yes, over the past three calendar years, the S&P 500 Growth Index has averaged 20.5% a year. But the S&P 500 Value Index has climbed just 6.8% a year, developed foreign markets 4.3% and emerging markets 6.2%. If you own a globally diversified portfolio—which you should—it would be hard to argue that all your holdings have been the subject of widespread feverish buying.
  3. We shouldn’t be surprised that investors currently favor stocks. What’s the alternative? Today, if you buy cash investments or high-quality bonds, you’re looking at returns that will likely leave you poorer once inflation and taxes are figured in. There are no guarantees stocks will make money this year or next. But for those hoping to clock decent long-run inflation-beating gains, they’re pretty much the only game in town.
  4. There are entirely justified concerns about political unrest, the rapid spread of COVID-19 and the vaccine rollout. But none of these things matters to the stock market, unless they drag down expected corporate earnings. It could happen, but it isn’t a sure thing—and, to the extent there might be an impact, today’s share prices already reflect those concerns.
  5. We’ve got crashes on the mind. Stock prices could collapse in 2021, just like they did in early 2020. That seems unlikely, but who knows? What is clear to me, however, is that last year’s 34% plunge by the S&P 500 is still a raw memory. Because early 2020’s market crash is so easy to recall, it’s also easy for us to imagine it happening again, and that—I suspect—is driving a lot of today’s talk of a market bubble.

To be sure, the pessimists sound worldly and sophisticated, while those who ignore them can seem naïve and reckless. But in truth, it’s the pessimists who are reckless. History tells us that nobody can consistently forecast the stock market’s direction, but most of the time the market heads higher—and it’s foolish to bet otherwise.

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This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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