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What is a Stock Bubble?

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As nice as it might be, a stock's price can't go up indefinitely forever. There's a theoretical limit to how much even the most optimistic investor might pay for a share of Facebook, for example. You might happily pay $1 per share and your neighbor who believes they're about to come out with a phone, a third-world ISP, and a self-driving car might pay $1000 a share, but there's an upper limit.

Even though not every investor practices value investing, which uses the real financial performance of a company to set the target price for a stock, psychology affects the sales price of many stocks. If enough people are bullish (thinking the stock's price will increase), the price will increase. If enough people are bearish (thinking the stock's price will decrease), the price will decrease.

As with all prices in a complex market, the details are complicated and these details include external factors, such as the price of similar investments. You could buy Treasury Bills or precious metals or bonds or even a simple CD or money market account at your credit union, after all. Yet if you're investing in stocks, you're probably doing so because you believe the returns you will get outweigh the risk you take on, especially when compared to other investments.

How do Other Investments Affect Stock Prices?

Consider for a moment Benjamin Graham's understated example. If you could invest $1000 in a US Treasury note and get 10% interest for essentially zero risk, wouldn't you do that instead of investing that same $1000 in a stock for 4% interest at greater risk? The math doesn't usually work that way, but the answer is obvious. Higher return and/or lower risk makes an investment more attractive.

That example's easy, but the world of investing is always in flux. This creates opportunities, but not all opportunities are good. During the years of quantitative easing in the early 2010s, the US Federal Reserve spent billions of dollars buying bonds and other securities, to increase the amount of money in circulation and to keep interest rates low.

While one of the loudest criticisms of QE was that it increased the amount of money in circulation (which, in a very simplistic and wrong economic model, was bound to cause hyperinflation—you can tell this economic model is wrong, because that hyperinflation never materialized), the most profound result was that interest rates went and stayed low.

Now do Graham's thought experiment again. That 10% return from a Treasury note suddenly became 1%. The risk is still nearly zero, but that return is terrible. Maybe your appetite for risk is still zero and the T note is still appealing, but for a lot of people the 4% stock return at a higher risk was a lot more attractive.

With more people buying stocks, stock prices went up and up and up.

What is a Stock Bubble?

A stock bubble is a hypothetical lament that stock prices are just too high. It's a complaint that stock prices are unrealistic based on the value of those stocks.

It's not always clear what "too high" means, because few people who complain about bubbles bother to explain the basis of a "fair valuation", but there are some measurements you can take to help you identify things.

All of the money flowing into stocks instead of bonds, thanks to QE, drove up prices beyond what people would traditionally pay, whatever "tradition" means. One such metric is the P/E ratio of the stock market as a whole. If people were willing to pay $10 for $1 of annual earnings in 2005 and $15 for the same $1 of earnings in 2015, that could be a sign that prices have gone up.

Alternately it could mean that expectations of profit globally have gone down. It's tricky to identify any single factor or another.

Do Stock Bubbles Affect All Stocks?

It's also tricky to identify any single factor as affecting the market as a whole when the stock market is actually a bazaar of tens of thousands of individual stocks that don't march in lockstep. Some companies grow fast. Some grow slowly. Some struggle and succeed. Others go bankrupt or get bought out or merge and disappear.

It's easier to talk about specific indexes such as the S&P 500. Robert Shiller's book Irrational Exuberance 3rd edition discusses the historical P/E of this index, and the website shows a nice graph including the current P/E.

Yet even so, the ratio of price to reported earnings doesn't tell the whole story.

If you're invested in the S&P 500 index, prices above the historical average may make the opportunity to invest more less attractive. If you're practicing dollar cost averaging, this may be less of an issue. Then again, if you start investing when prices are high and go to retire when prices are low, your target rate of return of 7-10% may be lower than if you started a few years earlier or later.

Who can predict that, though?

How Do You Protect Against Stock Bubbles?

Ultimately the nature of investing always includes some risk. The best you can do is mitigate that risk with research and understanding and patience. Despite bubbles and bear and bull markets and business cycles, the S&P 500 index has still given the most reliable earnings to risk ratio over long periods of time in the history of the market. That's no guarantee that it'll continue to be the gold standard of stock investing, but it's a pretty good baseline against which to judge everything else.

Also remember that, just because some widely tracked stocks and indexes have high historical P/E ratios, not all stocks do. Smaller stocks may have less liquidity, but this can also make them less susceptible to wide variations in price—and they can still be tremendously overlooked and undervalued.

Your best protection against getting swept up in a bubble is having a good, coherent plan that includes patience and diligence. Look for good companies that make real money, year after year. Understand what you're paying for and what kind of return you can expect in real dollars. Don't assume that ever increasing prices will continue to go up and up and up.

Look for great stocks at good prices and be patient. Bubbles will come and go, but the patient investor will see a good return either way.