With the Dow Jones Industrial Average and other indexes repeatedly hitting all-time highs — and with pundits warning that we’re in for a market correction, clients ask me all the time if we’re “in a bubble.” In reality, a bubble is simply a metaphor to describe when an asset class trades at a level that’s far beyond its intrinsic value. Now, when I say “asset class,” it could mean U.S. stocks; it could mean international stocks; it could mean bonds; or it could also be commodities, precious metals or oil.
There are many markets potentially moving into a territory in which investors become concerned about a bubble. An example of this phenomenon was the “Tech Bubble” that kept expanding in the late 90s and which ultimately burst in 2000. In the end, those high-flying stocks simply did not have sufficient earnings to support their lofty share prices which were trading far beyond their intrinsic values.
What entrepreneurs should know
I specialize in working with entrepreneurs who are approaching a liquidity event and they’re focused intensely on growing their businesses. These owners clearly understand the intrinsic value of their business, but their expertise is not managing investment portfolios or implementing any of the other complex advanced planning techniques that can ensure their peace of mind. That’s why they rely on me and my team to help them make smart decisions about navigating their financial waters. They also look to us to help ensure that they can sustain, and potentially improve, their quality of life.
When it comes to the intrinsic value of various asset classes, there are several things that I believe you always want to keep in mind. If you’re talking about a stock, some metrics to consider is the company’s price-to-earnings (P/E) ratio. Another is the price-to-book value (P/B) ratio. These are metrics that you always want to factor in, but P/E and P/B are just a small part of the story. Many investors tell me: “Well you know the P/E of the S&P 500 index is say 20 or 21, and that’s slightly higher than what it’s been historically, so that must mean we’re in a bubble, right?” Or they simply look at the overall level of the stock market, and say, “Well, the Dow’s at 22,000, so it must be a bubble.”
Here’s what you need to know: Whether the Dow is at 10,000 or 12,000 or 20,000 or even 22,000; those are just numbers. For the most part, those numbers don’t really mean anything unless you put them into the proper context.
Technically, the numbers associated with any stock index are based on the market capitalization of all the underlying stocks within that index. In the case of the Dow, we’re talking about 30 huge companies and none of the other thousands of publicly traded U.S. companies. Those 30 giant companies certainly aren’t “the market” however, “The Dow” (The Dow Jones Industrial Average) can be viewed as a “proxy” for the overall blue-chip stock market because of the dominance of the mammoth companies it is comprised of; however, the Dow should never be the only index you consider.
Real world examples
Remember the tech bubble of 1999 and 2000? At the time, technology stocks were trading significantly higher than their historic valuation levels, or if you looked at real estate during the financial crisis of 2008–2009, as S&O/Case-Shiller U.S. National Home Price Index details that asset class was trading more than 50 percent above its historic valuation. When we see outliers like that, we say to ourselves, “Okay, there’s something wrong here.” The problem is, everybody’s so happy making money during the bubbles that they turn a blind eye to the danger signs — until it’s too late. So in order to really determine if we are in a “Bubble” you need to look beyond the price of the market and understand how businesses are valued in the stock market. As I stated previously one of the metrics to look at is the P/E ratio which is simply calculated by taking a company’s stock price and dividing it by the company’s earnings So, if a company’s the stock price is $100 and its forward earnings are $5 per share, then it has a P/E ratio of 20 (i.e. $100 divided by $5).
How P/E can be misleading:
If the company’s stock price goes up and the overall market goes up too, while continuing to hit new highs, then the stock could still be fairly valued. Right? Suppose a company’s stock price increased by 50-percent to $150 per share from $100 and that the company’s earnings increased commensurately (i.e. by 50 percent as well). The stock could be hitting new highs and if you just looked at the price you might say to yourself, “Well you know, we have to be in bubble territory.” But, if the earnings can support the higher stock price, then the stock is NOT overvalued.
This is why a lot of people really don’t understand valuations. They look at the market and say to themselves, “Oh, we are at new highs. Maybe we should get defensive.” I hear this all the time. A friend recently told me, “Michael, maybe I should take some money off the table because we’re due for a correction.” I believe that kind of thinking is silly. I advise clients to think about a real estate investment. Everyone can touch and feel real estate. Many of our clients own multiple homes, plus residential rental and commercial properties and other types of properties. Real estate is very tangible to them. Let’s say you purchase a building for $1 Million that has both residential and commercial space. In essence you own a property asset, and then the asset throws off cash in the form of tenants who are paying you rent. Let’s say the rental income on your $1 Million building is a $100,000 a year (i.e. 10% of the building’s value). Now, suppose the building’s value increases to $2 Million over the next five years, but rents don’t keep up with the building’s increased valuation. It you’re still generating only $100,000 in rent (i.e. 5% of the building’s value), then that mismatch can potentially be considered a real estate bubble.
On the other hand, let’s say your rents increased in lockstep with the building’s increased value of $2 Million. So, if you’re now receiving $200,000 in rental income per year instead of just $100,000, that’s the same ratio as when you bought the building 5 years prior for $1 Million and earned $100,000 in rental income. In other words, the underlying valuation hasn’t changed the building’s higher price tag.
Now let’s take this example one step further. Suppose your building increased in value to $2 Million after five years, but rental income increased to $250,000 a year (i.e. 12.5% of the building’s value). The property is actually a better buy at $2 Million today then was five years ago at $1 Million. Why? Because the rental income it yields today is proportionally higher than it was five years ago.
I believe that it works the same in the stock market. If corporate earnings are much higher today when the Dow is at 22,000 than they were when the Dow was at 17,000, then the market could be considered a better value today and by that logic, you can recognize that you actually may be in bubble territory and in some scenarios actually find better valuations. Just remember it does not matter how high the price of a stock or the price of the index goes, what is important is how high the price goes relative to its underlying earnings. If a company is earning $100 Million today with a share price of $10 and if one day if the company grows and is earning $1 Billion it would make sense that the share-price should be significantly higher.
This is when it becomes challenging for folks in my position. Most investors still take the stock market at face value; they don’t have the right frame of reference to factor in things like earnings into their assessment of the market. They just look at the historically high value of the Dow or some other index and say to themselves: “Oh, the market’s way up; it must be due for a correction.”
Another example you may have stressed about, is when you see the pundits on the news spinning the hyperbole that “Stocks are hitting new highs, a correction is coming.”, “Get defensive, and we are due for a pullback.” I want you to understand that I believe that the markets are hitting new highs all the time mainly due to the constant rising cost of goods and services (inflation). Think about this. I am writing this sipping on my mid-day Starbucks coffee with a little steamed Almond milk and typing away on my new computer and just received a text message on my new iPhone. It is probably safe to say that the cost of these goods and services were the most I have ever spent on these items previously, in essence, they are all priced at “all-time highs”.
I can’t stress enough the importance of “looking under the hood” to determine if stocks might be a better buy at today’s high market values, than they were a few years ago when the indexes were lower. In many cases they are.
That being said, I have a few clients who DO like to look under the hood. Perhaps you do as well. We discuss metrics such as the Shiller CAPE ratio (Cyclically Adjusted PE Ratio), portfolio structure and statistics around multifactor investing to determine the standard deviation and Sharpe ratios of portfolios. I love this stuff, so I could talk about it for hours.
At the end of the day, many of my clients are just like you. They simply want to make sure they’re well positioned for what’s ahead in their lives. They want to make even smarter decisions about their portfolios and ensure that all of their complex financial affairs are well coordinated and not misinterpreting a bubble, or by being swayed by a media pundit who proclaims: “This time it’s different and you must go to cash!”
Many times the anticipated downturn doesn’t occur. Those who flee to the “safety” of the sidelines while pundits warn of a financial apocalypse, watch passively as the market pays no attention and continues its march onward and upward. One of the biggest mistakes I see investors make is going too soon to cash at the first sign of trouble. This is understandable, because the wounds are still fresh from the last bear market. Nobody wants to get blindsided again, especially you! Many investors blew themselves up when the tech bubble crashed in 1999 and 2000. Throughout the 1990s, exuberance and greed took over rational decision-making. When the music stopped, many investors lost a tremendous amount of their life savings. Its easy today to say, “They should have known better” since hindsight is always 20/20. What I find interesting is that we can all learn from these past mistakes so you are more informed and are able to make even smarter decisions.
If you or another successful business owner you know is concerned that the markets might be overheated, please don’t hesitate to contact me. I’d be happy to help.
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