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Why It’s Too Soon to Burst the Stock Price Bubble.

Why It’s Too Soon to Burst the Stock Price Bubble

What was yesterday’s big news? China’s economic growth.

The market expected bad news.

That’s why the S&P/ASX 200 index fell as much as 43 points during the day.

So, what happened?

It turns out the news was better than the market had expected.

After that came out the market turned course and went up. It ended the day down just 10.9 points.

So much for the idea that the market is living in cloud cuckoo land with too-high expectations. In fact, is it possible that investors are being unduly pessimistic and undervaluing stocks?

As always, you can never know for certain if stocks are undervalued, fairly valued or overvalued until after the event.

What seems expensive today may turn out to be cheap tomorrow if stock prices continue to rise and if company earnings follow suit.

That’s a key point. We’ll come back to that in a moment.

You’ve doubtless heard talk everywhere claiming that stocks are currently in a bubble. But what’s the rationale for that reasoning? That stock prices in the US have gained 170% since the 2009 low.

Likewise, many say Australian stocks are overvalued because the index is up 68% since the 2009 low. Let’s put things in perspective; as far as stocks are concerned there’s no way that anyone can reasonably call the current gains a bubble.

Not All Price Rises are Bubbles

Look, we’re not saying that stocks aren’t heading towards bubble territory. If you’ve read Money Morning at any point over the past five years you’ll know we’ve long warned about this gradually building bubble caused by low interest rates and money printing.

But it’s not there yet.

If you’re looking for a real bubble, look at the dot-com bubble. The NASDAQ index climbed 1,071% from March 1990 to March 2000. If Mick Dundee were comparing the two he’d probably say, ‘That’s not a bubble. THAT’S a bubble.’

We will point out one thing. Just because stocks go up – sometimes a lot – it doesn’t necessarily mean it’s a price bubble. It’s possible for prices to rise and for it to be entirely justified.

Diggers and Drillers resource analyst Jason Stevenson sent your editor a note in response to yesterday’s Money Morning. It was a quote in the Wall Street Journal from Jason Hsu, chief investment officer at Research Affiliates:

When everyone starts to use “bubble” anytime prices go up, it’s probably not one. The time to worry is when people are using all kinds of rationalizations as to why it’s not a bubble.

Hmmm. Does that mean it is a bubble because we’re claiming it isn’t yet the top of the bubble? Are we using ‘all kinds of rationalizations‘ to justify our position?

Well, that’s up to you to decide. We just give you the financial advice to buy stocks to take advantage of a rising stock market. As a self-directed investor it’s then up to you to decide if our argument makes sense…or whether we’re talking junk.

        Current Valuations ‘Cheap’ Compared to Bubble Valuations

Of course, we should make something else clear. Just because stock prices haven’t yet reached bubble proportions, doesn’t mean prices can’t fall.

Stocks rise and fall all the time. The issue is whether the price rise far exceeds anything that could possibly be justified by future earnings growth.

Even if stock valuations are high relative to historical levels, you have to decide whether they are so high that it’s fair to say the market is at the peak of a bubble.

The following chart details the average price to earnings (PE) ratio of the S&P 500 from 1871 to the present day:

The following  chart details the average price to earnings (PE) ratio of the S&P 500 from  1871 to the present day
Source: www.multpl.com
Click to enlarge

(Note: The data prior to 1957 is estimated data. The S&P 500 didn’t exist until 1957.)

We’ll agree that the PE ratio is towards the top of the average range. But as you can see, for a comparison to the dot-com boom and sub-prime boom, it’s plain to see current valuations are well below those bubble valuations.

Again, we’re not saying stock prices can’t or won’t fall. But the current market appears to be far from bubble territory…for now.

     It All Depends on Investor Confidence

Finally, we’ll make one last point. It’s something we referred to at the top of this letter.

It’s the idea that what may look like an expensive stock valuation today may not look so expensive a year or two from now. In fact, by then today’s stock prices could look cheap.

That can happen in one of two ways. Either companies announce better-than-expected profits, or investors become more positive about future company profits.

Look at the chart of PE ratios again. You can see how that’s played out in the past. If investors gain more confidence they’ll pay more for a stock in the belief that profits and prices will go higher.

Look, let’s get something straight. The whole period from 2009 is part of a major asset bubble. We get that, and we’ve openly warned you about it.

But just because we or others are supposedly smart enough to spot a bubble, doesn’t mean asset prices won’t go even higher. Price bubbles through history have a funny habit of going much further than most expect.

And right now, while the US market in particular may have clocked up good returns since 2009, we don’t think it’s anywhere near reaching a bursting point.

In fact, it may still be many years before the bubble reaches that point. In the meantime, it’s important you don’t miss out on the potential gains if this market continues to rise.

Kris Sayce.

This article is contributed by Money Morning. Click Here to Subscribe to their free newsletter.