Should investors worry about a bubble?

As the stock market continues its steep climb after last year’s bear market crash, it can test the nerves of even the most experienced investors. Some even worry about the possibility of a bubble. From March 23, 2020 to January 19, 2021, the S&P 500 rose 70% — even as the pandemic rages on and many businesses continue to feel the pinch. Should investors be concerned?

Market ups and downs are to be expected 

The question of whether there is a “bubble,” at least the way most investors understand the term, should be distinguished from “will stocks fall?” This is because short-term stock market pullbacks are normal and can occur without notice. The stock market experiences a few large pullbacks almost every year, including declines of more than 10%. Last year, there were twelve declines of 5% or more (the largest being 34%), which were the deepest since the global financial crisis. Still, the stock market made significant gains over this period despite these setbacks.

What should you do — and not do — when markets wobble?

It’s natural and expected that the stock market will fall at some point. But whatever the reason for investors to lose their nerve — global headlines, economic concerns, political uncertainty, etc. — historically, the market also has eventually recovered. Trying to predict the exact timing and nature of these declines often backfires, doing more harm than good. Staying invested and diversified through these events, no matter how uncertain they may feel, has more often been rewarded.

To distinguish between these short-term pullbacks and bubbles, it’s important to consider value. As with everything in life, what matters in investing isn’t just what price you pay but what you get for your money. After all, the reason investors purchase investments, is to own a part of a business and its cash flows. Thus, valuation metrics such as price-to-sales, price-to-earnings, and more tell us not just the price of a share — but what we’re getting for that price.

Are we actually approaching another bubble?

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The S&P 500 price-to-earnings ratio above is approaching levels not seen since the dot-com bubble of the late 1990s/early 2000s. However, this is due to many factors including the on-going pandemic. Sources: Clearnomics, Standard & Poor’s, Refinitiv.

On this basis, major stock markets aren’t cheap by historical standards. The S&P 500’s price-to-earnings ratio, at above 22 times next-twelve-month earnings, is approaching its dot-com era peak. Most other measures are also at their highest levels in the last 15 years.

Staying the course, and staying diversified, are key

There are two important points for investors to keep in mind: 

  1. It’s well understood why valuations are elevated. The on-going pandemic and economic restrictions have hurt earnings and other fundamental measures of company performance. Thus, they have pushed up valuations over the past year. The fact that investors continue to buy and stay invested at these levels suggest they believe sales and earnings can recover, thus bringing valuations back down to earth. Remember, stock prices generally reflect investor’s expectations as well as fundamentals that drive the valuations of investments. While there is still great uncertainty, this optimism has been rewarded since last March.
  2. Interest rates are still extremely low. In general, this can boost stock market valuation levels since there are fewer attractive asset classes that can generate sufficient income and low rates can reduce the cost of capital for companies, among other effects. While this does not guarantee that stock market valuations or prices can stay high indefinitely, this has been an important factor for over a decade.

Thus, while valuations are high, there are reasons this is the case today. Rather than constantly fear bubbles, investors may be better off staying the course, remaining diversified across sectors, styles and geographies in order to benefit from upside while protecting from possible downside risks. 

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