Geoff Gannon December 19, 2017

Are We in a Bubble? – Honestly: Yes

“Are we in a bubble?”

Right now: This is the most common question I get. For a long time, my answer to this question has been: “yes, stocks are overvalued but that does not mean the stock market has to drop.”

This exact phrasing has been my way of hiding behind a technicality. Technically, logic allows me to argue that just because stocks are overvalued does not mean they have to drop – after all, stock prices could just go nowhere for a long time.

And history does show that the combination of a sideways stock market in nominal dollars and high rates of inflation can “cure” an expensive stock market (see the late 1960s stock market Warren Buffett quit by winding down his partnership).

Unfortunately, the question asked was “are we in a bubble” not “do all bubbles pop with a crash”.

So, as of today: I will stop hiding behind that technicality.


What Today’s Bubble Looks Like

To get some idea of how expensive U.S. stocks are check out GuruFocus’s Shiller P/E page.

For a discussion of the psychological aspects of whether or not we are in a bubble, read two 2017 memos by Howard Marks: “There They Go Again…Again?” and “Yet Again?”

I don’t have much to say about the psychology of bubbles other than:

1.       When we’re in a bubble: I tend to get emails asking about the price of stocks rather than any risks to the economy or fears of a permanently bleak future.

2.       When we’re in a bubble: the emails I get tend to acknowledge that prices are high but then assert that there is no catalyst to cause them to come down.

3.       When we’re in a bubble: people tend to talk about their expectation for permanently lower long-term rates of return rather than the risk of a near-term price drop.

4.       And finally: when we’re in a bubble, people ask more about assets that are difficult to value.

This last point is the one historical lesson about the psychology of bubbles I want to underline for you.

Eventually, manic and euphoric feelings have to lead investors to focus on assets that are difficult to value.

It’s easier to bid up the prices of homes (which don’t have rental income) than apartment buildings (which do have rental income). It’s easier to bid up the price of gold (which doesn’t have much use in the real economy) than lime (which is mined for immediate use).

Generally, assets which are immediately useful are the most difficult to bid up in price.

Stocks without earnings are easier to bid up than stocks with earnings.

And stocks in developing industries are easier to bid up than stocks in developed industries.

The less present day earnings and less of a present day business plan a company has – the more a manic or euphoric investor can project on to the stock. The asset takes on a Rorschach test quality.

The 3 topics I get asked about the most are:

1.       Online groceries

2.       Electric cars

3.       Bitcoin

What’s notable about these 3 subjects is that they have investor adoption without consumer adoption.

Online groceries have the most consumer adoption at about 2% of U.S. grocery sales. Electric cars have less than 1% market share in the U.S. And bitcoin has no meaningful adoption as a medium of exchange.

Online groceries and electric cars have failed in the past. That doesn’t mean they will fail again now. However, it does mean that they are probably being attempted now at greater scale because funding is available for these ventures due to investor adoption running ahead of consumer adoption.

I’m an American who was born in 1985. So, I have only lived through two stock bubbles: the 1990s internet bubble and the 2000s housing bubble.

I said everything that needed saying about high stock prices in two posts written in 2006 and 2008 respectively. They are:

“In Defense of Extraordinary Claims” – December 29th, 2006: A post in which I argued that returns in U.S. stocks from that point in time forward would be below average, because “(the) great returns of the 20th century occurred under special circumstances – namely, low normalized P/E ratios. Today’s normalized P/E ratios are much, much higher. In other words, the special circumstances that allowed for great returns in equities during the 20th century no longer exist.”


On a Return to Normalcy” – October 10th, 2008: A post in which I argued that returns in U.S. stocks from that point in time forward would not be below average, because “at yesterday’s close of 8,579 the Dow is priced to grow at a quite historical six to six and a half percent a year.”

I ended the second of those two posts with the same postscript I’ll end this one with:

“All this brings up an interesting question – and I know a lot of people may not agree with my strict either/or dichotomy between a price drop or a stock market that does nothing for many years – but assuming the Dow’s normalized P/E had to revert to the mean for it to offer its historical returns once again…Which would you rather lose: Forty percent or eight and a half years?”

Because, either: the market will go nowhere between now and 2026 or it will drop by 40%.

That is what I believe.

Other investors believe differently. For example, there is a post called “Beyond All Expectations” by Of Dollars and Data.

That post is representative of the arguments used against declaring U.S. stocks in a bubble at year-end 2017.

I disagree with that argument.

So, I will declare us officially “in a bubble”.