The 21st century has given us one bubble after another: dot.com stocks, real estate, and commodities.
Bubbles are driven by excessive speculation. In a recent article by John Hussman, he states, “we can think of a bubble as an advance in an asset’s price to levels that are “detached from fundamentals” – essentially, the primary motive for investing ceases to be the expectation of future cash flows or consumption, and instead centers on the expectation of further increases in price.”
When an asset has reached bubble status, the investment makes no sense because its high price cannot justify the return on investment from future cash flows. For example, during the real estate bubble, investors had to “feed” their properties. That is, they had to take money out of their own pockets to pay the expenses since their cash flows were negative.
Valuation is the Most Important Metric
Valuation when you enter an investment is the biggest determinant of your success. Buying an asset for less than its intrinsic value, as Warren Buffet describes it, is the basic formula for success. In the S&P 500 (or any other index), long-term bull markets begin at low valuations (usually with an average P/E less than 12) and long-term bear markets start with high valuations (usually with an average P/E of over 20).
The last bull market in the US started in 1982 and ended in 2000. Over that period, people started assuming that the stock market was an easy and guaranteed way to make a return of 10-15% per year. Currently, we are in a secular bear market that began in 2000. Valuations were at all-time highs and the trend was unsustainable.
Where do we stand now?
Currently, valuations are still high with the Case-Shiller adjusted P/E at over 24. They were reasonable at the bottom of the market crash in 2009 but the rebound has risen to the point in which the next 5-10 year outlook looks to be below average. The rally that started in April 2009, John Hussman, believes is basically a mild speculative bubble. A lot of what may be driving the speculation is the anchoring of the stock price peaks we saw in 2000 and 2007. This anchoring gives the illusion that prices are not all that high.
The Case-Shiller adjusted P/E ratio is based on average inflation-adjusted earnings from the previous 10 years. The chart below from multpl.com shows the Case-Shiller index since 1880. As you can see, the adjusted P/E was around 7 in 1982 and rose to nearly 45 in 2000. In 2011, we still stand above the long-term trend. The chart also illustrates how P/E ratios are mean reverting over long periods of time.