Bubble Watch: Imagine What Would Happen If Optimism Reigned

 |  Includes: DIA, SPY
by: James A. Kostohryz


"Expensive" is not a synonym of "bubble."

Key ingredients of a systemically significant stock market bubble are missing.

What would happen to the prices of US stocks if Americans were actually optimistic?

As I mentioned in my report entitled "Peak PE," with the lone exception of the tech bubble period of 1998-2000, US equities on aggregate, as represented by key indices such as the S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average (NYSEARCA:DIA), are about as expensive as they have ever been since 1960.

However, "expensive" is not necessarily a synonym of "bubble." Indeed, several key ingredients of a systemically significant bubble are missing.

Aggregate Valuations Not Yet Indicative of A Bubble

The first missing ingredient is extreme overall valuation. While stocks on aggregate are historically quite expensive, aggregate valuation measures do not suggest the sort of irrationality that is characteristically associated with bubbles. A forward PE of 15.7 on mid-cycle earnings for the S&P 500, while expensive, is at least a plausible valuation for the market; bubble valuations by definition are scarcely plausible from a fundamental point of view.

No Dangerous Overvaluation In Systemically Important Sectors

Second, there is no systemically important segment of the market that is dangerously overvalued. Major market bubbles are typically characterized not only by high aggregate valuations but a high dispersion of valuation with extreme overvaluation in favored sectors that are systemically important. "Systemic importance," in this context, is defined as size relative to the overall market and/or economic significance.

Ironically, some of the most expensive segments of the market are in defensive sectors such as consumer staples. But the stretched valuations of fundamentally sound and prosperous companies such as McDonald's (NYSE:MCD) and Coca-Cola (NYSE:KO) (both trading at forward PE ratios of 18) are not indicative of extreme irrational optimism, nor do they pose any major danger to the US macro-economy or to the overall stock market.

Some critics like to point to segments of the market such as cloud computing or marijuana stocks as proof of a stock market bubble. But these segments are very small and systemically insignificant. The "bubbly" activity in such sectors represent mere warning signs that a larger and more systemically important bubble could be in the process of forming. However, they are not proof of a systemically significant stock market bubble per se.

Americans Are Too Pessimistic

Third, and perhaps most important, as I described in "This Time It Is Different: Americans Are More Pessimistic," the classic signs of extreme optimism or "irrational exuberance" are simply not there. To the contrary: Pessimistic long-term sentiment (as indicated by indicators such as the University of Michigan Consumer Confidence), anemic retail trading volumes and deep pessimism regarding US national leadership are symptoms that are simply not consistent with the notion that the US stock market is in a bubble phase.

Anecdotally, it is perhaps symptomatic of the deep pessimism that has gripped the national mood. My forecast of about 3.5% growth in the last three quarters of 2014 was met by a chorus of skepticism. Indeed, this forecast, explained in detail in my 2014 Economic Outlook, was even met with accusations that I was "drinking the Kool-Aid." This is quite a remarkable attitude given that the average rate of economic growth during economic expansions since World War II has been over 4.0%.

Indeed, the present age seems to be characterized by diminished expectations, not irrational exuberance.


I will conclude this essay with the following question: What would happen to the US equity market if the pall of pessimism were lifted and optimism reigned?

I will answer my own question: Look out above if the national mood brightens with the improvement in the US economy in the last three quarters of 2014.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.