Are We Experiencing a Market Bubble?

Monday, September 29th, 2014

It’s pretty difficult these days to flip through financial media talk shows or websites without hearing and seeing the phrase “stock market bubble”, i.e. the idea that market prices are wildly overvalued for a variety of reasons.

And, as all “bubbles” do, they will burst and stock prices will come crashing down without any warning.

Given the trajectory of stock market prices since March of 2009, it sounds reasonable.  But, only if you buy into the belief system that stock prices are random, irrational, unstable, rigged, and certainly not governed by any objectively verifiable standard.

The challenge with this belief system is history continues to demonstrate that, in the long run, any company’s stock price is very reliably correlated to the fortunes of the company it represents.

We always have to remember that stocks are nothing more than direct ownership in businesses, i.e. companies.  That’s what stocks are!

Now, it is certainly true that a company’s stock price (and, thus the broad market in general) can be affected in the short to intermediate term by political events, extremes in investor behavior, changes in interest rates, or other incidents not directly related to the operations of the underlying companies.

In the long run, however, stock prices have very consistently reflected the earnings, dividends, and cash flows of their respective companies.

During periods of cyclical or event-driven economic contraction, i.e. recessions, stock prices often fall.  Sometimes these declines reflect not only the prevailing conditions, but the public’s overreaction to them as well.

Although stock price declines often appear sudden, they’re not random.  It’s simply a reflection of the declining earnings and cash flows of the underlying company.

However, just as the decline of business activities of well run companies has been temporary, so too has the decline in their corresponding stock prices.

Are We Due For a Correction?

So, if there is no stock market “bubble” at the moment, aren’t we at least due for a correction?

Due? Yes.

Given that we haven’t even had a ten percent correction since 2012, and that the average intra-year correction since 1980 is 14%, we’d have to completely evade all historical perspective not to believe there’s one coming in the future.

However, as always, good luck to those who attempt to accurately predict exactly when prices will drop (and, more importantly, when they will rise again).

For humor, try to visualize the classic “sophisticated” investor attempting to accurately predict, and, thus “time” the market over the last six years!

Just as market price volatility (down and up) is and always has been normal, corrections are normal too and very much a part of the rational, long term, goal focused investment experience.

But, as we all know, corrections for the overwhelming majority have historically been uncomfortable while they’re occurring.  And, one of the biggest reasons they’re so uncomfortable is the beating of the drum by the financial media.

They’ll go to any length to reinforce that stock prices are random and irrational so you’ll stay tuned.

They love to perpetuate the myth of the common cliché: “this time it’s different”, i.e. the four words legendary investor John Templeton suggested were the most dangerous in investing.

We simply have to be on guard 24/7 to their tactics and remain grounded in what we know to be true in good times and in bad.

Temporary or Permanent?

What’s important to internalize is that market price declines have never been permanent, so when we experience our next correction, take comfort in the knowledge that it too will not last because they never have.

Specific to our current environment, the earnings/dividends/cash flow trends are far, far too strong, and the broad market’s price-to-earnings ratio is too average to sustain a large and long lasting decline.

The other factor strongly against a meaningful, long term stock market decline is cash!

Consider these two facts: at the end of the most recent quarter, Warren Buffett’s Berkshire Hathaway reported over $50 billion in cash on its balance sheet, something they’ve never had before.

Private equity is also estimated to be holding $1.165 trillion (with a “T”) in cash at the end of July.

Is there any chance that they’re just waiting for buying opportunities from irrational traders and speculators who get spooked by every short term correction and sell low?

What Can We Learn From This?

I don’t want you to leave this blog believing that a correction is not in our future.

I want you to walk away knowing that corrections are normal, inevitable, and temporary, and that you have no rational reason to fear one if you’ve done your homework and you have your holdings properly allocated.

The longer I’m at this, the more convinced I’ve become that market volatility is completely irrelevant if you are a long term, goal focused, well diversified investor.

We’re all in the business of owning assets that will help us overcome the inevitable erosion of the purchasing power of our income.

In good and bad markets, we can’t afford to get distracted and lose sight of this.