On The Bubble

4/7/2014


Q Some pundits say this market is a bubble waiting to burst. Do you buy the bubble blather?

A No. In an attempt to gain notoriety and attention, a growing number of market watchers seem to be racing to be the first to call the market bubble and the eventual bursting. However, the fact that a lot of people say this is a bubble is probably reason enough to say that it isn't a bubble.

Furthermore, the evidence does not support bubble believers. The broad market is not cheap. But it is not as richly valued as you would expect in a bubble. Despite a 20% gain over the last 12 months, the S&P 500 Index trades at less than 18 times trailing earnings, roughly the same earnings multiple as a year ago. The Dow Jones Industrial, Transportation, and Utility averages all sport P/E ratios at or below year-ago levels. The S&P SmallCap 600 Index trades at a P/E of 25, hardly cheap but only moderately higher than the P/E ratio of 23 of a year ago despite a 30% gain in the index.

Dividend yields for the major indexes have declined only slightly over the last year despite big price gains. And those dividend yields remain well above the yields on five-year Treasurys. 

To be sure, we see pockets of the market that appear excessively valued, tiny bubbles of sorts. And those pockets are attracting a lot of attention from the media and market watchers. For example, it would be hard to argue that the glamour stock Tesla Motors ($230; TSLA), which sells at 13 times annual revenues and earns a Quadrix Value score of just 6, is not overpriced.

But don't make the mistake of extrapolating from a highly publicized but relatively small sample set to conclude the broad market is in a bubble.

One last point: Even if the market has entered a bubble, such environments can last a relatively long time. The Forecasts considers it dangerous to heed the bubble talk and sell stocks en masse, especially with the market's primary trend still bullish according to the Dow Theory.

Q Isn't the plethora of initial public offerings (IPOs) so far this year a sign of a bubble?

A The increase in IPO activity does reflect increased interest in stocks and perhaps an elevated state of animal spirits among investors. But it is still a stretch to call today's IPO activity clear evidence of a bubble in the broad market.

For starters, the seasoning of most firms coming to market is higher than the IPOs of the late 1990s bubble period. According to Renaissance Capital, the average age of a company going public in 2014 is approximately 13 years. That compares to an average age of a little over 5.5 years for companies that went public between 1997 and 2001. While there are exceptions, today's IPO firms tend to be larger, with competitive positions in their markets. A return to a heavy flow of IPOs long on concept but barren of revenue and profits would be a "bubble" sign. But we're not there yet.

Q What about insider selling? Aren't insiders — corporate executives, board members, and major shareholders — dumping lots of stocks?

A Not really. A ratio above 20-to-1 is considered bearish. Readings under 12-to-1 are bullish.

After a sharp bearish spike in the ratio in January, things have settled down dramatically. In fact, the current ratio of roughly 15-to-1 is in neutral territory and at or below levels seen during much of 2013.  

Q What are some of the other sentiment indicators saying about the stock market?

A The equity put/call ratio — which uses options to measure the number of bearish bets on the stock market versus bullish bets — is running at levels generally considered closer to pessimism than optimism. The American Association of Individual Investors (AAII) weekly poll of its members shows roughly 31% are bullish, versus 29% bearish and 40% neutral — hardly the over-the-top ebullience associated with bubbles. Finally, Merrill Lynch's March survey of global money managers showed equity allocations at 15-month lows.


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