Is This A Bubble?
Everyone is familiar with the concept of a market bubble: periods of time where investors become irrationally optimistic, driving prices unreasonably high and setting markets up for an inevitable fall. The last bear market (stock prices fall at least 20%) bottomed on October 13th, 2022, and since then stocks have been in a general uptrend, known as a bull market. After three years of strong gains combined with the immense hype surrounding developments in artificial intelligence, many are wondering whether this bull market is turning into a bubble.
While it is always possible that markets go lower, current data indicates that no, we are not (yet) in a bubble. Let’s compare to the dot-com bubble, the most famous bubble in history. The dot-com bubble was full of companies making grand promises and being valued at billions of dollars despite low (or even *no*) revenue. Today’s companies are different; most of the winners of this A.I. cycle are large, established companies with billions of dollars in revenue.
A handy method of valuing companies is the P/E Ratio, which takes the price of a company’s stock and divides it by the earnings per share that the company generates. If we look at the aggregate P/E ratio of the S&P 500, we can see that the ratio is the same as it was at the start of the year:
What does this mean? The average S&P 500 company has grown their earnings by 12.6% this year, and guess how much the S&P 500 is up? 12.6%. In other words, 100% of gains in the S&P 500 have come from earnings growth, not “irrational exuberance”.
Next, let’s look at our current bull market side-by-side with the dot-com bubble. While our current bull market has provided impressive returns over the last 36 months, it pales in comparison to the run in the 90s:
As you can see, today’s market would have to run much hotter to contend with the dot-com bubble. Another feature of bubbles (and bull markets) is that they can run much longer than anyone thinks. Back during the 1990s, plenty of people were warning that stocks were in a massive bubble. One of the most outspoken critics was the Chairman of the Federal Reserve, Alan Greenspan. Greenspan correctly identified the bubble and called the market spike “irrational exuberance”, words that are now famous among investors. Great call right? Well:
Greenspan said this in 1996, more than three years before the bubble finally popped. As famed economist John Maynard Keynes said, “markets can remain irrational longer than you can remain solvent”. Here’s the most interesting detail though: when the bubble finally popped and stocks plummeted, the absolute bottom price for the S&P 500 was higher than on the day Greenspan made his “irrational exuberance” comments. Isn’t that incredible? If you moved to cash the day the Chair of the Federal Reserve declared a bubble and waited until the exact bottom of the selloff, you stillwould have underperformed an investor who just held on. As Mellody Hobson said: “The biggest risk of all is not taking one”.
No one can predict the future. I don’t know if stocks will rise or fall tomorrow, and I don’t know if this current market will turn into a bubble; what I do know is that current data says we are *not* in a bubble. More importantly, as I’ve said ad nauseum in this newsletter, the best long-term strategy is to buy and hold, tune out the distractions and fluctuations, don’t panic and stay focused on your long-term goals.