Cloudy with Scattered Bubbles

Each year in Seattle, our exquisite summer weather exits stage left in September, pursued by a bear worthy of Shakespeare: pervasive gloomy clouds and steady rain persist until next July. More rain accumulates in other cities, but we have more gray, cloudy days (usually 226/year).

Those many days of non-stop summer sunshine lead even the most careful to grow forgetful, leaving home without a rain shell, driving with joyous abandon on newly slick and dark roads.

So it can be too, in our financial markets, after so much sunshine.

We’ve lately lived through mostly sunny market prices. Except for April’s brief tariff tantrum, prices have risen, some rising even faster of late. Much ink has been spilled on the topic of market bubbles. Jonathan wrote this piece in 2021, before a big decline in both stock and bond prices during 2022 from a post-pandemic inflation spike.

It’s impossible to predict the future, including highs and lows of stock prices over any period. But as Warren Buffett noted in one famous speech at Sun Valley in 1999, valuing is not the same as predicting. By several measures, U.S. stocks are expensive as of market close on Sep. 30:

• Warren Buffett’s metric, which divides total market cap of all U.S. stocks by current U.S. GDP is +2.43 standard deviations (SD) over its average since 1950, a new high.
• Schiller’s PE, aka CAPE or CAPE10, is now +2.2 SD over its average since 1950, but below its most recent high of +3.0 SD in Dec. 1999.
• Price/Sales metric, which tracks the ratio of the total price of the U.S. stock market versus total sales revenue from U.S. companies, is at +2.6 SD over average since 2000.
• S&P 500 mean reversion quantifies how far market prices are off the index’s long-term average growth rate; that metric is now +2.25 SD, its highest since 1950.

While these measures are high, some at new records, they can move higher still. Once market speculation takes over, and day traders are having their fun, the exuberance can last for months or years. Or it can drop like a rock tomorrow. Such volatility is the admission fee for long-term stock returns in a portfolio, and that is the best way to build long-term wealth.

At times like this, it’s important to know what game you’re playing. If you’re a long-term investor, as are most HD readers, beware of taking buy cues from prices pushed up by day traders who sell quickly. The expected future returns of any investment bought at an exorbitantly high price will be either very low or negative. And the math of losses is brutal. Dollar-cost averaging, through regular small buys over many years, usually helps dodge this bullet.

Jeremy Grantham, a long-time value investor and student of market history, uses objective price measures plus “touchy-feely signs of euphoria” to call a bubble. Grantham writes that while no two bubbles are alike, they often share certain characteristics. Price that’s risen more than two standard deviations (+2 SD) over long-term average is one objective measure. Acceleration in the final price “melt up” phase of a bubble is typical.

And we have some winners on that account:

• Robinhood (HOOD): Up over 1600% since its recent low in Nov. 2023.
• nVidia (NVDA): Chipmaker darling of the AI boom, its stock is up over 1500% since its most recent low in Oct. 2022.
• Bitcoin USD: Up over 500% since its recent low in Dec. 2022. Whether you like it or hate it, it seems a lot harder to love at nosebleed prices.

Those three make growth of the next tier of bubblicious candidates seem slow:

• Tesla (TSLA): Despite global sales headwinds from its CEO’s impolitic comments, and the end of U.S. government EV tax credits, the stock is up 300% since its Dec. 2022 low.
• Cathie Wood’s ARK Innovation ETF (ARKK): A favorite tech growth ETF which dove off a cliff in 2022, ARKK is back in the clouds growing 150% since Oct. 2023.
• Microsoft (MSFT): This popular “Magnificent 7” stock is also getting an AI tailwind, growing over 130% since Oct. 2022.

The markets will always have pockets of exuberant buying, unmoored from measures of value. But when a broad market index starts outrunning its long-term average, you can almost smell the alcohol on Mr. Market’s breath. Vanguard’s S&P 500 ETF (VOO) is up over 80% since Sep. 2022, more than twice its long-term average monthly growth rate.

Even gold has gotten in on the act, now up over 130% since Oct. 2022, growth that has run far ahead of inflation. Gold prices like this remind me of Howard Marks’ quote “there are no bad assets, only bad prices.” Price matters.

Here are a few thoughts for these tricky investing times:

1. Don’t stop believing. If you’re young and working, tune out all market news because this, too, will pass. Keep shoveling money into your 401(k). Dollar cost averaging (DCA) through regular paycheck contributions ensures high prices will be offset later when the market corrects.
2. Check your parachutes. If you’re approaching retirement or retired, ensure your plan includes enough in cash and bonds to avoid the need to sell stocks when prices are later depressed. Temper your expected return assumptions for the next few years. If the stock portion of your portfolio has grown over the past few years, consider rebalancing. Or not.
3. Percentages not prices. Keep the primal panic parts of your brain in check: focus on percentage changes in prices, or better still, focus on percent change in total portfolio value. A drop of $10,000 sounds bad, but in a $500,000 portfolio that’s just 2%.
4. Aim for the middle. As Adam Grossman has noted, we get in more trouble when we take steps that land us in extreme positions. Satisfying long-term returns are more likely to happen when we aim for the middle of the road. For instance: take more care when investing large sums of cash during high market prices, perhaps using DCA for half, then do three or four buys, guided by historical value measures, for the rest.
5. Prepare for the sale. Eventually, stocks which have become crazy expensive will drop, first to a price range most would consider fair market value. If we’re lucky, they’ll drop further, priced at a deep discount for those who have the cash and courage to buy when others are fearful.