What makes a stock market bubble and are we in one?

Stock markets exhibit cyclical behavior, fluctuating between bear and bull markets. These cycles generally span several years, although the transition from one to the other can occur rapidly. This is exactly what the well-known market adage “taking the stairs up and the elevator down” signifies.

These inflexion points are most usually associated with sharp moves to the downside, as the market moves from being predominantly bullish to predominantly bearish. And for that to happen traders need to undergo a complete reversal in sentiment towards the market.

The biggest changes come when traders are only looking in one direction - when new information or change in circumstances pulls the rug from under their feet.

Tunnel vision among traders is one of the facets of what's known as a stock market bubble, a kind of collective hallucination about the market which rarely if ever ends well.

Why do bubbles occur？

Bubbles occur when markets have been moving in one direction (upward) for a prolonged period, they say a rising tide lifts all boats, and so it is with the stock market.

However, all stocks are not created equal, and the longer that the bull market goes on, the further down the market food chain, traders need to go to find stocks that could deliver the type of returns they have gotten used to.

In these circumstances, traders start to ignore market fundamentals and long-term averages and the valuations for stocks creep ever higher - effectively traders are paying more to own less.

We move into bubble mode when traders start to ignore or block out the warning signs. For example when the share prices of stocks, with no credible business plan or chance of making money rise sharply, or when PE ratios and other multiples trade well above their long-term averages, without the commensurate growth in underlying earnings or revenues.

That behaviour is compounded by traders who then, start to ignore contra opinions and voices, that have different views to theirs.

Confirmation Bias

In the worst-case scenarios traders ignore these contra opinions completely and seek out only those opinions that support their view of the market, and nothing else.

This is known as confirmation bias and its possibly one of the most dangerous tricks that our minds can play on us, especially where our finances are concerned.

Having surrounded themselves with like-minded thinkers, traders then fall foul of what‘s known as availability bias, which happens when you only rely on information that’s at hand to make a decision, rather than considering the bigger picture.

The Emperor's New Clothes

At some point the music stops and traders realise the error of their ways and the overvalued and mono-directional nature of the positions they are holding. That would be okay if it were not for the fact that every other trader, inside the bubble, comes to that realisation at the same time, or very shortly after.

And of course, everyone heads to the exit at the same time, and thats never a pretty picture.

The question we must ask ourselves is are we in a stock market bubble right now？

The chart below shows the change in the 12-month forward price-earnings or PE ratio of the S&P 500 index, versus the price performance of the index over the last ten years.

As of December 8th the S&P 500 was trading at a forward PE ratio of 18.80 times earnings. This is bang in line with its 5-year average, but above the 10-year average of 17.60 times earnings, according to Factset data.

So for the moment the S&P 500 is trading above its long-term average PE ratio but not excessively so.

The Magnificent Seven

Of course most of this year's gains in the S&P 500 have been driven by a very select group of stocks, which have picked the nickname of the Magnificent Seven.

So it seems sensible to look at how those stocks are valued relative to history.

The Magnificent Seven trade at an average PE ratio of around 48 times earnings, far higher than the 5 and 10-year averages for the S&P 500 as a whole.

But of course, these stocks are anything but average, and growth and technology stocks typically trade on far higher multiples, than say old economy and value stocks.

Bank of America recently looked at the valuation of the Magnificent Seven and compared that to the Dot.com boom of the late 1990s, one of the most notorious stock market bubbles.

The bank found that the Magnificent Seven would need to see their share prices rise by +55.0% before they would even reach 50.0% of the valuation multiples achieved by the seven largest tech stocks, during the Dot.com boom.

A move that incidentally would add +15.0% to the S&P 500 according to the BofA calculations.

So whilst we look likely to end 2023 on a high, as far as many equity indices are concerned, we are nowhere near bubble territory yet.