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Is the US stock market in a bubble?

Updated: Jun 4

The US stock market continues to hit record highs as President Biden enters the White House. We look at what investors need to know when it comes to stock market bubbles.

finger pointing on screen stock graph

Bubble trouble?

As we’ve entered the start of the new year, the US stock market has continued to climb to record heights. Veteran investor Jeremy Grantham has gone as far as to say we’ve reached “a fully-fledged epic bubble.”

The market is, in some ways, highly rated if we compare it to its history. And there’s a fair amount of excitement around some companies and sectors. But that doesn’t necessarily mean we’re in a bubble.

Instead, the decline in interest rates since the 1980s could both explain and justify the market’s higher rating. And this could also be part of the reason the US market has performed so well since the Financial Crisis.

Even if the US stock market isn’t in a bubble, there are still risks. All share prices can fall as well as rise, and this article isn’t personal advice.

Why do some people think we’re in a bubble?

This idea we’re in a bubble comes from a few places:

  1. Stocks have had a good run for a little over a decade now. Since just after the Financial Crisis, the US stock market has returned 560% including dividends (source: Refinitiv Datastream, 1/3/09 to 14/1/21).

  2. The US market currently trades on a cyclically adjusted PE ratio (more on how this works later) well above its long run average, even though the real economy has suffered one of the biggest shocks on record.

  3. An over-optimistic view of the US stock market from investors.

Bubbles make people nervous because they have a habit of bursting. You do need to look at the risks carefully though. Remember, it’s important to hold a diversified portfolio and past performance isn’t a guide to the future.

The Cyclically Adjusted Price Earnings (CAPE) Ratio

A normal price/earnings (PE) ratio is an investment’s price divided by its earnings or profits. In this case, we’re looking at the S&P 500. If company profits vary from year to year, a PE ratio can be misleading as profits could be unusually and unsustainably high or low.

For example, profits at lots of companies were a lot lower in 2020 because of the coronavirus pandemic. A PE ratio could be misleading if investors expect those profits to recover.

Nobel Laureate Robert Shiller instead divides the price of the index by the average of its earnings in the last ten years, all adjusted for inflation. That way, ups and downs in earnings are smoothed out to give a less jumpy picture of the market’s valuation. This type of PE ratio is called a Cyclically Adjusted PE, or CAPE, ratio. It’s also known as a Shiller PE ratio.

Shiller has calculated this ratio for the US stock market back to 1881, giving us lots of data to work with.

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