August 3, 2020

Is there a stock market bubble? Why it doesn’t matter.

Stocks are funny.

For decades people have tried to come up with ways to beat the system, fads have come and gone, and bubbles have exploded dramatically. Economists have talked about the efficient market hypothesis or the castle in the air theory, and talking heads on the TV have rallied people into states of euphoria or sent them into a wave of panic. The thing is, we never know what is going to happen next.

Want to know how you could become undoubtedly the richest person in history? By knowing the future. You could buy and sell stocks at the right time, gamble on the right teams, or create the next wave of technology. The problem is, it’s impossible. As far as our technology has come, and for as much as the human race has advanced, we cannot see into the future.

One of the most helpful criteria used to get a glimpse at the future of a company’s stock is the price to earnings or P/E ratio. Historically, 15 is the average P/E ratio indicating a company’s stock is priced appropriately. If the P/E is low, say 10 or less, then the stock is particularly cheap and may be due for a rise in price. A low P/E occurs most frequently during market crashes but that’s not to say you won’t see that during a bull market either. On the other hand, a P/E of 25 or more typically indicates an expensive and overvalued stock. To put our current state in perspective, the average P/E ratio of all companies that make up the S&P 500 is approximately 26. This in itself is not a reason to signal the alarms, but with the significant growth from 2009-present, there’s a good chance that many stocks are falsely inflated.

There are many reasons for the drastic increase in the market over the past 7-8 years but one of the most influential is the historically low interest rate, controlled by the Fed. In order to keep the American economy from crashing into the abyss during the 2008 fiasco, the Fed cut rates to nearly 0 and pumped cash into the system to get things started again. The problem is rates can’t be at 0 forever, it’s simply not sustainable for the economy. So they have begun to hike the rates back up slowly but surely and have been even more cautious with the situation due to a new incoming president. December 2016 was the most recent hike to just under 1%, with several rate hikes expected in 2017, as early even as February. Increasing the national interest rate has helped to fight inflation in the past but perhaps more importantly, a rise in interest rates have been known to prick bubbles.

Am I suggesting that there is going to be a major crash in the next 5 years? Absolutely not. But is it possible? Sure. In fact, a crash would be nice. Although painful at the time, it helps to cool the market and provides amazing buying opportunities. On the other hand, what if we are just in the beginning of the greatest bull market of all time? In 1995 people started talking about how they thought stocks were overvalued but the insanity had not even begun. Imagine if you had taken all your money out and missed the next 5 years of growth? Of course, the market corrected its course in 2001 but in 2000 you would have been kicking yourself for what you had done. If you want to be a speculator and jump in and out of the markets, you may do so at your own risk, but understand this is the most likely way to lose money on Wall Street. If instead you want to be an investor, your money should stay in one place for decades at a time. That will build wealth. In fact, the only time you should remotely worry about the price of the stocks you own is when you are retired and need to sell for your income. Otherwise the sticker price is useless and will only make you do stupid things with your money. You just need to remember to keep a brave face and don’t convince yourself or others that “this time it’s different”. Guess what, it’s not. And if it really is in fact different this time, we’ll either all be rich or painfully broke and have to deal with our problems together.

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