Don't Listen To Bubble Speculation

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Includes: DIA, QQQ, SPY
by: Robert Singarella Jr.

Summary

It's not worth investor's time to listen to the endless bubble speculation. Most of the arguments in support of a market bubble are weak.

Valuation measures cannot help with market timing; they work well only when considering long time periods.

Economic data does not indicate an imminent recession.

As you can see above, the Dow has spent the last week or two hovering around a significant numerical milestone. In fact, there were several days when the Dow closed above that value leading to a flood of poorly thought out doomsday articles (here's a particularly bad example of a doomsday article). In spite of the nonsense, we can still learn something from all of the noise the financial media is generating; specifically, what not to do. All investors are human and are therefore subject to cognitive biases when making investment decisions. When cognitive biases are mixed with the misunderstanding of valuation metrics, the result is usually bad decisions. I'll start with the misunderstanding of valuation metrics.

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Source: data provided by Robert Shiller, graph from multpl.com.

The chart above is Robert Shiller's CAPE (Cyclically Adjusted PE) ratio. CAPE has been in the news a lot over the last few years; however, if you are not familiar with CAPE, here is a brief summary. CAPE is calculated using a 10-year, inflation adjusted, moving average of the PE ratio. The moving average allows for much of the short-term volatility to be filtered out, providing a much better indication of the long-term potential for the stock market. The long-term average value for CAPE is 16.54 and the current value is 26.06; about 57.55% above the long-term average.

In fact, the overvaluation suggested by CAPE has a lot to do with the amount of attention it has been given in the last year or two. There are several metrics that indicate the market is currently overvalued, but CAPE was one of the first indicators to suggest the market was overvalued. With the significantly negative bias in the media's market outlook and the many pundits calling for a crash, CAPE became the indicator of an imminent crash. The problem is that CAPE is not a tool for timing the market, to see that, consider the chart below.

Source: Bloomberg View.

There is no better way I can think to make the point. The current value of CAPE has very limited predictive power over a 1-year time span. Also, keep in mind that the chart is showing median returns; it's not an absolute predictor of returns. CAPE is telling us that we should expect stocks to do poorly in the long-run at current valuations, but it's not saying anything about a correction, crash, or a bubble. I would also suggest caution when working with valuation metrics such as CAPE; it's best to use more than one before you decide if the market is overvalued. My final point on valuation metrics is that they all suffer from the same problem that CAPE does, to a great extent. There are no measures that can tell you when a crash or correction is coming.

Now, you may argue that there are other reasons to believe that there is a market bubble other than CAPE: QE, length of the current bull market, the VIX, all time highs, economic ruin, and so on. I've already addressed the VIX in a previous article, so I will not cover that here. With respect to the others, I will direct readers to one of my favorite articles about the problem of storytelling in the context of investing (The Narrative Fails). However, I will provide a few data points that indicate the economy continues to move in the right direction (and therefore is not going to cause a market crash).

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First, the unemployment rate has continued to decline, though it remains elevated. Clearly, unemployment is moving in the right direction and does not show signs of stalling or reversing. Even if we expand unemployment to include marginally attached workers (chart below), the situation is still improving. Given the magnitude of the financial crisis, it's not hard to believe that the recovery will take much longer than for a less serious recession. Furthermore, the improvements in both measures of unemployment appear to be accelerating. While I can't predict the future, that certainly doesn't fit with the idea of a slowing economy.

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This leads me back to the point I mentioned above about the narrative. Much of the doom and gloom outlook on the economy is politically motivated. It doesn't matter what your political views are; keep them out of your investing decisions.

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There is one final point I would like to make about the absence of a market bubble. The chart above is the National Financial Conditions Index (NFCI) subindex (one of three) measuring nonfinancial leverage. From the Federal Reserve website:

The three subindexes of the NFCI (risk, credit and leverage) allow for a more detailed examination of the movements in the NFCI. Like the NFCI, each is constructed to have an average value of zero and a standard deviation of one over a sample period extending back to 1973. The risk subindex captures volatility and funding risk in the financial sector; the credit subindex is composed of measures of credit conditions; and the leverage subindex consists of debt and equity measures. Increasing risk, tighter credit conditions and declining leverage are consistent with tightening financial conditions. Thus, a positive value for an individual subindex indicates that the corresponding aspect of financial conditions is tighter than on average, while negative values indicate the opposite.

The nonfinancial leverage subindex of the NFCI best exemplifies how leverage can serve as an early warning signal for financial stress and its potential impact on economic growth. The positive weight assigned to both the household and nonfinancial business leverage measures in this NFCI subindex make it characteristic of the feedback process between the financial and nonfinancial sectors of the economy often referred to as the "financial accelerator." Increasingly tighter financial conditions are associated with rising risk premiums and declining asset values. The net worth of households and nonfinancial firms is, thus, reduced at the same time that credit tightens. This leads to a period of deleveraging (i.e., debt reduction) across the financial and nonfinancial sectors of the economy and ultimately to lower economic activity.

Just one more sign that we may not be on the edge of a cliff. No recession, in the data provided, started when the leverage subindex had a negative value. It provided a good warning about the financial crisis and some degree of warning before the dot-com bubble burst. The economic data points to continued recovery, not recession.

Just to be clear, I'm not saying that there will be 10 more years to this bull market. My point is simply that claims of a market bubble are fairly weak. Even if there is a bubble, I would be willing to bet that most pundits are wrong about the reasons, and they only get the timing correct by luck. That's just how the market works; it's only easy in hindsight.

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