How to tell if we're still in a stock market bubble
The best tests for knowing if you're in a stock market bubble
Issac Newton created the laws of motion, half of the base of calculus, and the law of Gravity. Here is a short version of a lesser-known part of his life. In the early 1700’s there was a business in Britian called the South Sea Company. The business made up at its peak around 70% of the British stock market. They had a monopoly on the trade to Spanish Colonies. The stock was a way to access a promising new industry that was set to boom. Issac Newton initially invested in 1719 and made 7,000 pounds or an inflation adjusted 460,000 dollars after selling in less than year. Inflation am I right. He sold the shares because he saw the stock price rising rapidly and worried about the speculation going on. Then he saw the stock continue to climb and climb and bought back in at a way higher price. The bubble burst months later and he lost an inflation adjusted 1.3 million dollars, or an estimated 50% of his net worth. Afterwards he made a statement that has been quoted in many contexts for centuries
“I can calculate the motions of heavenly bodies, but not the madness of people”
While not quite as intelligent as Issac Newton but still super super smart Benjmain Graham would have been able to calculate the “madness of people” more accurately the intrinsic value of the business. But Issac Newton didn’t comprehend value investing so that’s why he basically just pushed his mistake off on society being completely illogical (which it was) rather than a flaw in his own reasoning (which could have prevented the loss). In this respect we should strive to not be like Issac Newton. That is what today’s article is about.
I generally speaking do not think most people’s investment strategy should be affected drastically by the market circumstances. For example, if you want to ever have a 100+ bagger in the stock market, it will take anywhere(typically) from 15-30 years. There are of course going to be major crashes during the holding period, but it would have been a bad decision to sell any of those real compounders. However, for many people it is useful to make some adjustments. So, why not give it my best shot at determining some useful tests for a market “bubble” AKA a very high/expensive market.
While there are many measures trying to figure out how optimistic or pessimistic the market is, I would like to present 5 that I believe are very useful. When you are in the depths of a bear market, you know that the market is being more pessimistic. It is becoming a more well-known fact that the emotional response for loss and gain are not similar. Charlie Munger understood this when he somewhat pretentiously coined the phrase “super deprival reaction syndrome” Losing a dollar, feels on average twice as bad as it felt good to gain that dollar. So in a pessimistic market it is not as hard to tell what’s going on. While feelings can easily get in the way of good investing through emotions like fear, greed, or boredom(impatience), emotions can actually tell us things our brain cannot explain at times. In the book The Righteous Mind by Jonathan Haidt, he explains how when people have a traumatic brain injury and no longer feel emotion, their decision-making process can become quite nutty. We do not know how to think well without some emotion.
In the euphoria of a bull market, one can try to weasel themselves into thinking that valuations are not “insane”, these companies are can’t miss blue chips, or forget the danger of owning a bunch of mediocre, optimistically priced securities. Even very smart people like Issac Newton can fall victim to the herd mentality So, for the reasons laid out it would be somewhat useful to be able as Howard Marks says, take the temperature of the market. Not to think in absolutes, all in or all out, but to at least understand the “mood” of the broader investment base. I will also try to show more unique measures that are not as typically used but just as useful. Also, we will be focused on a bubble in the U.S stock market exclusively. This is in no particular order.
1. U.S households % of assets in stocks
Every U.S household has a couple options for growing wealth. Buying real estate, bonds, stocks, gold and a few other options. Stocks are always an important piece of this, but they will only ever be so much of the pie. There are always going to be retired people who need steady income from bonds, families who wish to own a home or invest in real estate, and weird people who like gold as a doomsday hedge like my friend Alan. Seeing how much of people’s assets are in stocks helps to tell us two things. It tell us how people feel about stocks; if people have a higher than average amount of their money in stocks, it is an indication that they feel comfortable and bullish on stocks. It also tell us that the stock market itself has gone up relative to other assets and increased itself as a percentage of people’s money. Be careful to see what is included as “assets” in the indicator you use. When this indicator is historically lower than average, it is highly correlated with good future returns, and in the opposite case… I think you can figure out the rest.
2. Difference between the PE of the U.S stock market and the average abroad.
As stated earlier, this post is specifically about testing the temperature of the American stock market. It is also not about forecasting, it’s not about the current market, and it is not about all in or all out. It is about providing the reader with solutions to the question to be more defensive or more aggressive. Whenever you see the U.S stock market with a Price to Earnings above pretty much every other country in the world, you at least know that it is going to take a lot more good things to happen to America’s economy relative to rest of the world, for that to have been logical. The principal assumption of good investment is conservative estimates, action, and valuation.
3. A more qualitative test: Is there new technology or a sector that has become the darling of the market that is supposed to be the future?
As Howard Marks astutely pointed out, it is difficult for there to be a market bubble if there is no new grand innovation. When dealing with an industry like chemicals, cereal, or textiles it is difficult for investors to have grand visions of future growth. They are more likely due to both the boring industry, and long history of returns in the industry, to be realistic about it’s prospects. The dot com bubbol had the internet, the GFC had MBS’ and CDO’s, and we had AI.
4. When you see people around you with zero knowledge of what they are investing in making lots of money.
When the most poorly thought-out ideas are putting up great returns fast, you know investors are acting only with greed in mind and not fundamentals. I have been seeing this plenty the past couple years. And I can tell you it is painful to see people who genuinely have no idea what they are doing, making lots of money, and expressing that they are exceptionally perceptive because *blank* is the future. I know people who have invested in stocks that they didn’t even know it was unprofitable, never knew that it became a meme stock, and then claim later they made a fantastic decision after it soared. Charles Kindleberger put it quite well “There is nothing so disturbing to one’s wellbeing and judgement than to see a friend get rich” I think the quote is especially true when the person you know is getting rich through unintelligent ways. When you’ve been feeling that a lot lately, it might be a good indication that you're in a bubble.
5. What the best investors are doing and saying
Just a month ago the signals of warning were there when Warren Buffet is hoarding cash, Howard Marks most recent memo expresses lots of caution, and Monish Pabrai has ruled out the chance of bargains in the American markets, it should be a hint that it is not a good environment for bargains. One of the most obvious but best ways to get an idea of the market’s price, is to look to the best.
P.S
The word bubble unlike in investing can be a positive word, for example my girlfriend Elena(who has provided valuable information in thinking about Ulta and Elf beauty) and I use the word to describe a place of peace
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