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Is It A Bubble If Everyone Sees It?

spherical droplet framing tulips
17th century "tulip mania" is widely considered the first economic bubble. Photo by Flickr user photophilde.

Long-running gains in U.S. stocks have some professionals using the “b” word again. But is the equity market really in or approaching a bubble?

A recent Bloomberg survey suggests many investors, analysts and traders think so. Dane Fulmer, an Arkansas-based trader, compared market conditions to an oncoming storm, saying, “You don’t have to be a weatherman to see clouds.” Meanwhile, usually bullish analysts have remained atypically cautious about the growth potential for stocks over the rest of 2014; though few are outright pessimistic, many are hesitant to predict much more growth, if any.

Is a bubble possible if everyone sees a bubble? While it is possible, it is not likely. Market psychology doesn’t usually work that way.

Bubbles generally occur when crowds convince themselves that the constraints or concerns of the past no longer apply. “This time is different” is an atmosphere in which bubbles inflate. Investors convince themselves that assets that have soared in value - be they tulips, or gold, or oil, or stocks - can only keep going up.

Consider the example of the dot-com bubble of the late 1990s. The initial success of many pioneering online businesses led to an overly broad sense of optimism, in which investors jumped on what turned out to be the top of stock prices’ crest in the firm belief that even companies without solid earnings and business plans would create massive returns. The Internet turned out to be a useful tool, but not, as The New York Times said in 2000, “an indiscriminate, magical new means of making money.” Yet because so many investors convinced themselves that their choices were rational, the cycle became self-perpetuating until the bubble ultimately burst. In a bubble, investors believe an asset’s value can only move one direction. They’re usually right - just not about which direction.

That atmosphere, however, is not what we are experiencing right now. While more expensive today than they have been in recent years, stocks are still not terribly pricy compared to companies’ earnings, which is what really matters. Many of the companies in the S&P 500 that have posted their earnings have beaten analysts’ estimates and exceeded sales projections, which gives optimism about stocks a reasonably solid foundation.

Perhaps more importantly, stock prices are not very expensive when compared to today’s extremely low interest rates. Those interest rates are themselves something of a bubble in the value of bonds, whose value increases as rates fall. So the inevitable rise in interest rates will most likely be bad news for stock prices eventually. But even a moderate rise in rates will leave bond yields at historically low levels - levels that, in the past, have not been a big hindrance to stocks.

The Federal Reserve recently agreed that, in general, investors “are not excessively optimistic regarding equities,” and that valuation measures were “generally at levels not far above their historical averages.” While the Fed’s biannual report did express concerns about certain sectors, specifically social media and biotech, it also mentioned low volatility; Bloomberg reported that the VIX, a measure of volatility, dropped to a seven-year low in early July. While some bystanders think the Fed’s certainty is unwarranted given its track record, there is real reason to think that corporate earnings, and not blind optimism, have underpinned the market’s rise.

As always, future stock prices depend on future corporate earnings or, more accurately, the expected future earnings of companies. If the outlook for economic growth, employment, wage growth, global trade, government finances and tax policy is reasonably favorable, stocks could continue to rise a lot higher than current levels.

That’s a big if, of course, not likely to be satisfied in all particulars, and possibly not in most of them. Certainly there will be another bear market at some point down the road; there always is. I am not making a prediction here about whether the current bull market has a long time to run. I can’t know with certainty whether or not it does, and neither can anyone else.

I am merely observing that a bubble, by definition, occurs when prices really only have one direction to go. Right now, stocks seem to be traveling on a two-lane road with very little objective evidence to serve as a signpost that we have entered bubble territory.

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