4 Reasons We’re Not In a Stock Market Bubble

And 4 ways things could change

As the S&P 500 and Dow Jones Industrial reach all-time highs, many investors are clamoring that we are in a stock market bubble. We’ve been hearing it for a while. “The bull run has lasted for too long”, “The market is just too high” and “We’re overdue for a correction.”

While a lot of that may be true, does it mean we are in a bubble?

To answer that question, I called up my friend. His name is Data. He’s one of the most honest people I’ve ever met. Let’s see what he said — his words, not mine:

1. The S&P 500 P/E Ratio Is Under 20

Please take a moment to study the S&P 500 P/E ratio over time. You may observe that while a P/E of 18.5 is not cheap, it is also not high, and certainly not in bubble territory.

During the dotcom bubble, P/E broke 30. Later, it broke 40 and 50 as the recession hit.

S&P 500 P/E Ratio over time, courtesy of Multpl.com

So you, like some of my friends, might argue that the Case Schiller P/E is too high. I’ll gladly hear you out if you’re already well aware that the Case Schiller P/E takes 10 years of data and averages it out, and that means this means that you are including P/E data from the 2008–2009 to compare to other bubble periods. Maybe it’s just me, but IMHO it’s a bit skewed to include data from the greatest recession in US history and compare it to other periods to call bubble.

2. GDP Continues to Grow

Sure, growth is not outstanding by any measure. But consensus is that US GDP will grow (source: http://knoema.com/qhswwkc/us-gdp-growth-forecast-2014-2015-and-up-to-2060-data-and-charts). Take a glance at US GDP projections for 2015+. Surprise: They are steady and positive.

US GDP Growth Forecasts, courtesy of Knoema

3. High Risk Assets Are Getting Crushed

A telltale sign of a bubble is rising prices across most (all) asset classes. What we have now, however, is a falling small cap index as measured by the Russell 2000. This means that investors are dumping smaller, high risk companies, implying a rotation into other, potentially less risky, asset classes. That shows prudence, which is the opposite of the exuberance witnessed near the peak of a bubble. Here’s a chart of the Russell 2000 Index ETF, courtesy of our friends at TradingView: https://www.tradingview.com/e/tAYA6HeO/

4. The VIX Is Up, So Naturally, You Are Panicking

I absolutely love seeing panic headlines as the VIX spikes dramatically. The VIX, for those who aren’t yet familiar with it, is a volatility index. It measures the prices of options on S&P 500 futures. When the S&P 500 fluctuates wildly, its option prices rise as investors seek protection, and as a result, so does the VIX.

The VIX is also called the “fear index”, and perhaps rightfully so, because it generally gauges investor fear. So it seems quite natural that as investors are panicking, the VIX is rising sharply.

Another thing I love about the VIX in bull markets — and this is not a proven or repeatable statement, just a general observation — is that it usually spikes and drops dramatically as investors overreact and oversell. This generates great buying opportunities for those who have been sitting back instead of tracking every dollar decline in their portfolio. Check out these nice panic moments, followed by very sharp declines as people regained their cool. It’s like a dysfunctional couple that issues life threats to each other and moments later is making love. The yellow highliths the life threats (“making love” withheld to keep it PG).

So What Could Go Wrong?

Not everything is rosy. Here are afew things that worry me right now — these are just my opinions:

Weakness in Europe and Russia as the DAX breaks support and Russia braces for recession;

Resulting weakness in demand for China;

Continuation of asset class rotation, leaving some investors in the dust as they fail to keep up with the new;

Lofty valuations in large cap internet tech stocks that trade on absurd revenue multiples and rely on earnings beats for share price increase; and

Perhaps this doesn’t worry as much as it interests me — this chart of the VIX, same as above, but zoomed out:

Please share if you have a bubble-calling friend and comment to disprove or strengthen any points.

Have a nice weekend!