Are We In A Stock Market Bubble?

2017 has been an exceptional year for stock markets across the world. The start of 2018 has been no different at all. This has got many people wondering whether we are in a manic phase. There is no reason why this possibility should be ruled out.

The Dow Jones Index has seen an uptick in every month of the previous year. There has been no discernable reason for the index to rise so fast. This has got many investors wondering whether they are in a melt-up phase.

A melt up phase is the run-up to a crash. Here asset prices increase at an alarming rate driven by nothing but positive sentiment. This situation aptly describes what is happening to equities all over the globe.

There are many analysts who do believe that we are in a bubble. On the other hand, many do believe that this isn’t a bubble. In this article, we will have a closer look at both sides of the argument.

Why Does it Seem Like a Bubble?

• GDP to Market Cap Ratio: Warren Buffet has used GDP to market capitalization ratio as being the number one indicator to predict stock bubbles. The current value of this indicator is 145%. This is way beyond the average of 75%. In fact, it has only been at a higher value once in history.

  The ratio had a value of 148% just before the dot come bubble of 2001 exploded. Hence, if this indication is to be believed, the stock market in America is highly overvalued right now. The situation is no different for stock markets world over. This may be one of the biggest bubbles in the history of the world.

• Market PE Ratio: Just like GDP to market cap ratio, the PE ratio is a simple indicator which provides a rough estimate as to whether the market is overvalued. Like the GDP to market cap ratio, the PE ratio is also overvalued at historic levels right now.

  The average PE ratio for the New York Stock Exchange hovers around 21. It has almost doubled and now stands at 40. Many people believe that this is because the markets expect increased profitability in the future. However, there is no reason to be optimistic as of now.


• Growth Rate Comparison: The increase in the share price of the value usually has high correlation to the increase in the earnings. At the present moment, this is not the case. The earnings are growing at a very slow pace for the past 2 years or so.

  Most companies have registered run of the mill mundane performances. However, valuations seem to be growing at an incredibly fast pace. This makes it sound eerily similar to the tech bubble of 2001 when the valuations were soaring to record levels without any reason.

• Low-Interest Rates: The Federal Reserve has held the interest rate in America at record low levels. This has been done to spur growth and recover from the stock market disaster that happened in 2008. However, near-zero interest rates mean that stocks are not facing any real competition.

  No one is investing in instruments such as certificates of deposit etc. Almost all the money has found its way into the stock market.

  Many analysts believe that soon the interest rates will rise and the party will be over. Fed chairman Janet Yellen has already raised the interest rates. This is likely to continue in the future as well.

• Tech Stock Euphoria: During the 2001 crisis, the majority of the valuation was flowing into a handful of tech companies. In the 2001 crisis, the companies leading the charge were Microsoft, Intel, Cisco, and Dell. Now too tech companies are driving the market. Only now Facebook, Amazon, Netflix, and Google are leading the charge.

  Consider the fact that Jezz Bezos has become the richest person in the world during this period. He has more wealth than Bill Gates ever had!

  Also, note that Netflix stock has grown by 2500% during the past five years. Although both Amazon and Netflix are companies with strong fundamentals, the valuations seem to be a bit stretched.

Why It Doesn’t Seem Like A Bubble

• Moderate Inflation: Many analysts believe that the current valuations are sustainable as long as the Fed does not drastically raise the interest rates. Hence, inflation comes into the picture. The Fed only raises interest rates when inflation is out of control.

  Right now, the inflation rate in the USA is not growing at an alarming rate. Hence, the probability of a steep rate hike is dismal. Therefore, even if it is a bubble, this one is likely to be sustained for some time.

• Responsible Lending: The subprime mortgage crisis, as well as the 2001 tech crash both, saw irresponsible lending to varying degrees. Many experts believe that a bubble is impossible till irresponsible borrowing becomes the norm. They believe that this is not the case now.

  Companies and banks have both been careful to avoid irresponsible lending. Also, companies have not hired too many people and taken up liabilities.

Crashes can only be predicted in hindsight. This is because, before the crash, there are always different arguments that try to convince people that “this time it is different”.

All major investors have warned that the Bull Run might be over and bears might take over in the next 12 to 18 months phase.

Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.