Investors Can't Ignore This Clear Sign Of A Stock Market Bubble

Summary

• Rapid growth compared to historical averages can look like the sign of a bubble forming.
• When you put stock markets in a long-term perspective they don't look like a bubble.
• Individual stocks may rise quickly but that could be a sign that they have real value rather than being a bubble.
• It pays to be cautious. You also need to be aware of where there is real growth potential.

The other day I saw a comment on social media saying "index funds are a bubble". After a civil and thoughtful discussion I got some more details.

Apparently this graph was cause for concern:

(source)

When you put it beside a chart of any major stock market index such as the S&P 500 (SPY) the resemblance is clear:

(source: Google Finance)

With a rise that quick in recent years, how can it be anything other than the early stages of a bubble?

I did a quick experiment. I took a clip showing another quick rise, and got confirmation that it does indeed look like a bubble that's forming:

(source: Google Finance)

That looks like a dangerous situation! In fact it comes from this chart of the DJIA (DIA) -- the segment shown above is circled in red:

(source: Google Finance)

Chart Blindness

It turns out that this is not in fact a sign of a bubble forming.

You know those maps that make Greenland look like the biggest country in the world? That's not true, it's just what happens when you draw a sphere inside a rectangle. Areas near the poles look much larger than they really are. Despite the error those maps are still common.

Price charts are similar. They make changes from a higher starting price look bigger than they really are. It's just what happens when you draw a compounding (exponential) series of prices in a linear chart.

The early years of compounding look like nothing is changing much, when compared to a later period after it has really built up. A 10% change from a price of $2,600 looks a lot bigger than a 10% change from a price of $260. This is an illusion but the charts are still everywhere.

If we didn't expect exponential growth no one would invest in stocks. Smaller returns, or non-compounding returns, can be had with much less risk if you choose other investments. The biggest reason to even consider buying stocks is the possibility that you will earn high and compounding returns over a long period of time.

There can still be unsustainable growth. Nothing in the financial world can grow at 100% a year forever, for example, because it would eventually be more valuable than everything else in the world.

Yet we need to be careful not to ignore real, sustainable growth. It's hard to tell the difference between a bubble and normal compounding in a typical price chart. They look the same (unless you're extremely sensitive to very small changes in the depth of the curve).

For maps the most accurate view is an actual globe. For compounding prices the most accurate view is a logarithmic chart like this one showing S&P 500 returns:

(source: Google Finance)

On this chart every 10% gain looks the same regardless of what price it starts from. The rise from 2400 to 3000 is much smaller than the rise from 600 to 1200, because it represents 25% instead of 100% gains. You can use that "Settings" link at the bottom to switch to this view.

Now we can see three parts:

• 1980 - 1994 has steady and healthy returns (the second half includes a crash and a recession)
• 1995 - 1999 is a clear bubble, with much steeper gains
• 2000 - 2017 is nearly flat with two crashes and a slow climb above the previous peak

It looks like the opposite of a bubble. Has the market been deflating for over 15 years?

Maybe not -- we have to take into account that 2000 was in fact the end of a bubble. If you draw a line from 1980 - 1994, and continue along that line, it nearly goes off the chart by 2017.

But then the 1980s were a remarkably good decade for stocks too. It's justifiable that we haven't kept up that pace uninterrupted.

In the end it looks like the pace of growth in the stock market is actually quite normal.

Bubble Companies

Ok so that wasn't a bubble. But what about individual companies with a skyrocketing valuation? Take this example:

• Year 1: <$10m valuation
• Year 2: $85m valuation
• Year 3: $500m valuation
• Years 4 - 5: $15b valuation

That can't be anything but a bubble. Right? No company could sustain growth that fast without falling back.

Or maybe it could.

That was Facebook's (FB) funding history from 2004 - 2008. Today the valuation is $550b, somewhat higher than it would be if those initial gains had been a bubble.

Now imagine that I've discovered a new, shiny substance under the ground. No one has heard of it before but I manage to convince someone to buy a handful for $0.06. A year later I've sold a similar handful for $8.50.

Another year passes and I'm still getting barely $10.5. But 12 months after that I get it to $120.82 per handful. After a surge of excitement it dies down a bit, and the next year it's selling at $502.89.

Definite bubble right? And yet what if I could convince people all around the world to buy this "gold" (GLD) for $1350/oz, giving the total amount a value of around $10 trillion?

Ok, that's a somewhat fictional account. The price series is the actual prices of Bitcoin (OTC:GBTC) from 2010 - 2014.

I can't make any guarantees about whether Bitcoin will become the gold of the future. However this illustrates another source of false bubble claims.

If something new is created or discovered, and it is going to have a very large value in the future, then at some point the price will rise rapidly.

As long as the price is below that long-term value the rapid increase does not mean that it's in a bubble. If you are going to imply that it's in a bubble you need to justify a lower long-term value rather than saying the price is rising too fast.

Why Stocks Keep Compounding

Remember that high compound returns can persist when the base of investors is shrinking.

The reason that stock market returns can be higher than the growth of the economy over a long period of time is because many investors end up selling their stocks and leaving the market.

They invest to get future income and that future income means unloading their investments. When this happens they stop getting compounding returns which allows higher compounding returns to go to the remaining investors.

If you stay in the market longer than others you get higher returns than them. You could also see this effect if you buy a dividend stock and you are one of the few holders who reinvest their dividends.

The Bubble In Bubbles

I hope no one takes this to mean that you should forget all caution. The biggest thing it takes to be a good investor is to say no to a lot of promising opportunities. If you can't preserve your capital you'll find it hard to make profits.

At the same time you need to find growth somewhere. If you've done thorough research and you have a lot of reasons to believe in your chosen investments, you don't want to be thrown off because a bunch of people are calling it a "bubble".

We're now seeing a second-order reaction to recent history. The bubbles happened because investors forgot that prices can go down. As a result of the crashes investors have forgotten that prices can go up. When no one has mentioned the word "bubble" for a year or two you should be concerned.

Compounding returns over a long period produce results that the human mind struggles to understand. It always looks like a bubble. That's why we invest.

Do check that your projections don't end up with unrealistic results (like unemployed people buying a few million-dollar homes, or a company with no profits or cashflow being worth $50 trillion). When you get results like that you need to rethink your assumptions. Otherwise you can tune out the noise.

Disclosure: I am/we are long VTI, FB, BITCOIN. 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.