Is the Bubble Risk Elevated?

Bubble talk is back and for obvious reasons. The stock market has been on a tear and valuation has soared. Classic signs of a bubble, right? Maybe, but it’s usually best to proceed cautiously before declaring that the end is near simply someone tells you the jig is up.

When market bubbles pop, the results are painful, especially for investors who were clueless holding portfolios positioned for maximum risk exposure. But timing risk is no trivial thing either. Going all-in with defensive moves may not be cost-free either. How to proceed? Thoughtfully, which starts by recognizing that timing bubble estimates is a risk in its own right.

As one example, Federal Chairman Greenspan at the end of 1996 famously observed that the stock market’s frothy run looked like “irrational exuberance.” He wasn’t wrong, as far as these things go, but as investment advice it came at a price. Following that speech, the S&P 500 Index proceeded to more than double before peaking in early 2000.

Similar events can be cited throughout history. There are also cases of Wall Street seers who correctly timed bubbles – Marty Zweig’s prediction of the 1987 crash, is often cited as the gold standard of foresight.

But as a practical rule, it’s best to assume that most of us won’t be as lucky (skillful?) in calling bubbles in real time. The next best thing is developing context that’s relevant for your particular investment strategy and rebalancing on a regular schedule, perhaps with an opportunistic twist at times.

Let’s start with one of various bubble metrics I run to keep an eye on the degree of market froth. To be clear, the chart below measures bubble risk in a very specific way, and one that may or may not resonate with everyone. But it’s a start, and at the moment it suggests that bubble risk is low. The basic approach here is to calculate the rolling 12-month percentage change in the monthly average of the S&P 500 Index and search for a unit root (or the absence of one) via the Augmented Dickey-Fuller test. In short, use a statistical test to identify periods when the one-year return looks unusually high (with indicator values ranging from 0 to 1.0). The current reading is 0.26, which suggests that bubble risk is low.

Useful to know, perhaps, but let’s recognize that the stock market can still fall sharply even if its not in a bubble. This is a good time to remember that S&P 500 drawdowns up to -10% are common and are rarely linked with bubbles.

None of this is to dismiss the main catalyst for the recent bubble talk – high valuation. The Cyclically Adjusted Price Earnings Ratio (CAPE Ratio) has almost never been higher over the past 150 years. Unless it’s different this times, this metric suggests that US equity market returns will be lower for some period of time into the future relative to the recent past — a forecast that resonates in my long-term expected return estimates.

On a shorter-term basis, the market looks a bit overbought, but not excessively so relative to history, based on a home-grown estimate via the S&P 500 Sentiment Momentum Index.

Meanwhile, the bulls aren’t giving up so easily. Ed Yardeni, president of Yardeni Research, notes: “S&P 500 earnings per share continue to beat expectations. Q3 earnings per share are on track to rise to a new record high. They are driving the S&P 500 stock price index to new record highs. The Magnificent-7 are leading the way higher on both fronts.”

Driving the optimism is a surge in capital expenditures to build artificial intelligence infrastructure, which is expected to fuel a new era of growth and prosperity. Sparkline Capital, however, warns that a new boom-bust cycle may be lurking, again:

“The AI revolution has reached a key inflection point, with the largest U.S. tech firms embarking on a massive AI infrastructure buildout. While the market has rewarded this spending so far, we find that historical capital expenditure booms have typically resulted in overinvestment, excess competition, and poor stock returns – both at the macro and individual firm level.”

How should investors respond? First, recognize that there are two sets of risks: Ignoring what may or may not be a bubble, and assuming that you can time it accurately. To address these twin threats start with the standard advice: stay diversified through a global asset allocation strategy and rebalance, perhaps tactically at times.

On that basis, monitoring how a global asset allocation strategy is performing is useful, and arguably superior to watching the US stock market in isolation. As I discussed in The ETF Portfolio Strategist this week, there’s a case for waiting for relatively clear trend warnings to pop up for deciding that some degree of defensive posturing is timely.

At the moment, the tell-tale signs of correction have yet to emerge. That could change, and perhaps quickly. But rather than speculating about what could happen, or not, most investors are wise to ride the current trend via a globally diversified portfolio until it gives you a relatively clear warning in forecast-free terms in real time that trouble is brewing.

Such a tipping point isn’t conspicuous… yet. Tomorrow, however, is another day.

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