Is a Market Bubble in Sight?

In a bubble, investors believe assets’ value can move in only one direction. They’re usually right – just not about which direction. Long-running gains in U.S. stocks, despite sharp daily dips over this summer, inspire some market watchers to use the B-word again.

Is the equity market in or approaching a bubble?

A recent Bloomberg survey suggests that many investors, analysts and traders think so. Dane Fulmer, an Arkansas-based trader, compared market conditions to an oncoming storm, saying, “You don’t have to be a weatherman to see clouds.”

Meanwhile, usually bullish analysts remain atypically cautious about the growth potential for stocks over the rest of 2014. Though few are outright pessimistic, many hesitate to predict much more – if any – growth.

Is a bubble possible if everyone sees a bubble? It’s possible but unlikely. Market psychology doesn’t usually work that way.

Bubbles generally occur when crowds convince themselves that constraints or concerns of the past no longer apply. Investors convince themselves that assets that soared in value – be they tulips, gold, oil or stocks – can only keep going up.

Consider the dot-com bubble of the late 1990s. The initial success of many pioneering online businesses led to an overly broad optimism; investors jumped on what turned out to be the top of stock prices’ crest, firmly believing that even companies without solid earnings and business plans can still create massive returns.

The Internet turned out to be a useful tool, but not, The New York Times said in 2000, “an indiscriminate, magical new means of making money.” Because so many investors convinced themselves their choices were rational, though, the cycle self-perpetuated until the bubble burst.

That atmosphere is not ours right now. While more expensive today than in recent years, stocks remain not terribly pricy compared to companies’ earnings, which is what really matters. Many of the companies in the Standard & Poor’s 500 that posted earnings beat analysts’ estimates and exceeded sales projections, giving optimism about stocks a reasonably solid foundation.

Perhaps more important: Stock prices are also not very expensive when compared to today’s extremely low interest rates. Those rates constitute something of a bubble in the value of bonds, the value of which increases as rates fall.

The inevitable rise in interest rates will most likely mean bad news for stock prices eventually. But even a moderate rise in rates will leave bond yields at historically low levels – levels that (also historically) do not greatly hinder stocks.

The Federal Reserve recently agreed that, in general, investors “are not excessively optimistic regarding equities” and that valuation measures were “generally at levels not far above their historical averages.” While the Fed’s biannual report did express concern about certain sectors (social media and biotech), it also mentioned low volatility; Bloomberg reported that the VIX, a measure of volatility, dropped to a seven-year low in early July. 

Though some see the Fed’s certainty as unwarranted, real reason exists to think that corporate earnings, and not blind optimism, underpinned the market’s more-or-less steady rise. If outlooks for economic and wage growth, employment, global trade, government finances and tax policy remain reasonably favorable, stocks might continue to rise a lot.

That’s a big if, of course, not likely to be satisfied in all particulars. Another bear market will hit at some point.

But a bubble, by definition, occurs when prices really only have one direction to go. Right now, stocks seem to travel a two-lane road with few signposts pointing to bubble territory.

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Larry M. Elkin, CPA, CFP, is president of Palisades Hudson Financial Group LLC and Palisades Hudson Asset Management, L.P., in Scarsdale, N.Y.

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