How Do You Easily Spot a “Bubble”?
“The market looks like it could drop any day. When do you expect it will crash?”
I’ve received this question a lot — from readers, members of my family, and colleagues.
I’m sure you’ve been wondering this too.
Honestly — it’s a good question…
Back in June of 2020, I began to see just how “disconnected” the markets were. Meaning, the stock prices in no way reflected the underlying economic realities of the Corona Crash or pandemic.
Now at the end of August 2021… The markets are only more disconnected.
And as I mentioned last week…
When market prices become irrationally divorced from underlying realities and value, you have a “bubble.”
Just how insanely disconnected is the stock market from economic reality right now?
Let’s take a look at the plot below from the Nobel-prize winning economist Robert Shiller.
The chart shows the price of the S&P 500 compared to the combined earnings of all the companies in that index:
[The S&P 500 is the index that Wall Street uses to measure the overall performance of the stock market. Earnings is a company’s net profit.]
Notice how that blue line is really far from the green line?
That’s what I mean when I say “disconnected.”
The bigger the disconnection, the more likely it is that we’re in a bubble.
Economist Robert Shiller used this same data to create an indicator he calls the cyclically adjusted price-to-earnings ratio, or “CAPE.”
This indicator takes the price of the S&P 500 and divides it by the average of 10 years of earnings for the companies in the index, adjusted for inflation.
But what you really need to understand about this ratio is…
The higher the CAPE ratio, the more overvalued the market seems to be.
When I say the word “overvalued,” what I mean is “seems expensive for what you’re getting.”
And right now, Shiller’s CAPE indicator is around 38.
According to Barclay’s bank, that makes the U.S. stock market one of the most expensive-seeming in the world.
While it continues to fluctuate, this CAPE measurement is still near the highest it’s ever been.
It has reached its highest level since the 2000s tech bubble and recently surpassed its peaks just before the 1929 market crash.
In both instances, investors were punished for years after the fact.
And we can make a guess about when this is going to happen, because the CAPE allows us to determine the implied future annual market return, assuming valuations return to their averages.
You can see the relationship between the two in the chart below… the Shiller CAPE is in green and the implied future return is in blue:
As you can see, the higher the CAPE the worse expected returns are. The lower the CAPE, the better expected returns are.
Should the S&P 500 CAPE ratio return to its historical average…
You should expect to see the average annual return over the next 8 years be about -5.1%.
Here’s what the returns look like if the CAPE grows or declines to different levels…
Basically, future stock market returns are…
Well, if I’m being polite, I’d say they’ll be sub-par.
Another word to describe them is “trash.”
This is why, at the end of a previous post, I mentioned that I’m reluctant to suggest investing in major market indices like the S&P 500 right now.
Over the next decade, the big opportunities, as I see them, will be investing in certain individual stocks when they’re well priced, useful cryptocurrencies, non-correlated market assets, certain commodities, and alternative assets.
I’ll introduce how you can invest in the future.
“SEAN, WHAT DO I DO IF THE STOCK BUBBLE BURSTS?”
Here’s what I suggest:
Don’t worry about a market crash. So long as you’re investing in quality assets with a long-term perspective, you’ll be fine.
Treat downturns as an opportunity rather than as a threat. Some of the best returns come from buying at the moment when the market is most oversold (and when everyone is panicking).
And finally, we’re potentially entering a decade where growth and appreciation will probably be lower than average. For that reason, I predict that investing for cash income — such as put option premiums, dividends, and interest — is going to be one of the best performing strategies for the next few years.
