Stock Market Bubble? Not Yet, But Never Hurts to Prepare for the Possibility

Wednesday, March 3, 2021 |

Ray Dalio is one of the clearest writers on the markets. When he puts something out, I usually jump at the chance to read it. His latest insight – “Stock Market Bubble” is no different: I found it to be particularly relevant given today’s environment.

I suggest reading the whole thing (not long), but here is a quick summary:

  • Dalio puts together a metric that essentially combines the following factors: historical valuations, earnings growth relative to bond yields, sentiment/exuberance/leverage. Using a diversified metric as opposed to just 1 (usually historical valuations) should create a more balanced view of the current conditions.
  • The broad US Stock Market is frothy, but not in bubble territory with a reading around 80% (2000 reached 100%)
  • There is however a wide divergence across the broader market between Stocks that are in bubbles and not in bubbles. Certain pockets (e.g., possibly Emerging Tech) are in extreme bubbles. Some Stocks are not in bubbles at all as only about 3% of the S&P 500 stocks are in a bubble per Dalio’s metrics.
  • These bubble companies have drastically outperformed the broader market over the last 14 months


In light of the above, what are some strategies you may want to consider:

  • Keep Enough Cash/Bonds: Stock Market prices will recover over long periods of time, but you do not want to be in a forced liquidation position in Stocks if they are in a drawdown.
  • Reduce Exposure to the Bubble Sectors: This is hard as we do not have Dalio’s data on which parts of the Market are in bubble; however, you can probably get a pretty good idea based on the relative strength of the Sector relative to the Market. You could also implement a downside protection strategy.
  • Stay Diversified: The more Value Stock oriented parts of the market (see chart below) and International Stocks appear to be less frothy than broader market. You could also use an Equal Weight Index in concert with a Market Capitalization Index.
  • Buy Good Companies: Stocks with predictable, stable growing revenues and wide moats are likely to compound over time and less likely to reach bubble levels. Even at higher valuations, over time these types of Stocks are usually rewarded.
  • Rebalance: If your allocation is becoming more concentrated in the frothier parts of the Market, consider pairing it back and/or trimming it when the market begins to show relative strength to the less frothy parts.
  • Stay Invested: If you look at Dalio’s Bubble Chart you will see that we have reached the current metric of ~ 80% multiple times and the market has delivered good returns over the intermediate term. Moving to Cash now could potentially miss out on those returns for a decade + before the Bear Market happens.
  • Keep a Long-Term View: Stocks are long-term assets, not meant to be held for a year or 2. We don’t know when a Bear Market might occur or elevated valuations revert; however, we are fairly confident that over time Stocks will deliver returns in the 6% to 10% range. The longer you hold them, the greater the probability of reaching those returns.
 

Chart Source: Koyfin | Red Line Shows Declining Performance of IVE (S&P 500 Value) vs SPY (S&P 500) 

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Capital Analysts or Lincoln Investment. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. No person or system can predict the market.

Past performance is not indicative of future results.

S&P 500: The index measures the performance of 500 widely held stocks in the US equity market. Standard and Poor's chooses member companies for the index based on market size, liquidity and industry group representation. It is market capitalization-weighted. Investors cannot invest directly in an index.

Equal weight is a type of weighting that gives the same weight, or importance, to each stock in a portfolio or index fund, and the smallest companies are given equal weight to the largest companies in an equal-weight index fund or portfolio.

Investing involves risk, including the loss of principal. There are some risks associated with investing in the stock markets: 1) Systematic risk - also known as market risk, this is the potential for the entire market to decline; 2) Unsystematic risk - the risk that any one stock may go down in value, independent of the stock market as a whole. This also incorporates business risk and event risk; and 3) Opportunity risk and liquidity risk.  International investing involves special risks, including, but not limited to, the possibility of substantial volatility due to currency fluctuation and political uncertainties.

IVE = The iShares S&P 500 Value ETF seeks to track the investment results of an index composed of large-capitalization U.S. equities that exhibit value characteristics.  Value investments focus on stocks of income-producing companies whose price is low relative to one or more valuation factors, such as earnings or book value.  Such investments are subject to risks that their intrinsic values may never be realized by the market, or such stock may turn out not to have been undervalued.  Investors should carefully consider the additional risks involved in value investments.

SPY = The SPDR® S&P 500® ETF Trust seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index (the “Index”)

Projections or other information regarding the likelihood of various outcomes are hypothetical in nature, do not reflect actual results and are not guarantees of future results. Additionally, it is important to note that information in this report is based upon financial figures input on the article date; results provided may vary.

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