Economist John Maynard Keynes noted, “The market can stay irrational longer than you can stay solvent.” With the S&P 500 and Dow both making new all-time highs amid a bevy of reasons the market should be much lower, there has been more “bubble” talk creeping into conversations. So, the big question for investors becomes, is the market acting irrationally or not?
Whether the market is in a bubble usually isn’t known until well after the fact, but there are typically clues along the way that things are getting extremely stretched. We noted one such concern in our Weekly Market Commentary this week, as the 12-month trailing price-to-earnings (PE) ratio on the S&P 500 broke out to an 11-year high. Valuations tend to get much higher at true bubble peaks, but they are still nowhere close to the 30 level that was reached at the height of the tech bubble in the late 1990s.
Probably the best way to determine if something is in a bubble is by how vertical the price has been. Looking at a seven-year annualized return of the S&P 500 (back to when the bull market began), it recently reached 15%, which last happened during the tech bubble and right before the 1987 crash. If all you had was this chart, you could argue prices are extended and maybe a bubble could be forming.
Here’s where it pays to take a different angle on things before making a decision. The S&P 500 peaked in August 2000, or 16 years ago next month. Looking at the 16-year annualized return shows a much different picture than the chart above. Taking this approach shows that the annualized return was recently 2%, the lowest since July 1982 and August 1953. Both times were right before major bull markets that lasted years.
Therefore, either now is the worst time to be long stocks since the tech bubble, or the best buying opportunity since 1982. That’s confusing, isn’t it? In reality, we are probably somewhere in the middle of these two extremes—and not in a bubble. We continue to think we are late in the economic cycle, but the odds of a recession over the next year or two may still be rather low. With earnings looking to potentially rebound over the second half of this year and yields near historic levels, equities may be one of the better places to beat inflation over the near term. Sentiment is something we didn’t talk about today, but have in the past. Although sentiment levels are much more optimistic than they were a few months ago, most sentiment indicators are still nowhere near past major market peaks. Be on the lookout for next week’s Weekly Market Commentary, when we will take a closer look at sentiment.
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The economic forecasts set forth in the presentation may not develop as predicted.
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The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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