Is the Stock Market Currently a “Bubble”?

Warren Buffett, 1966

Sir John Templeton

Toward the end of March, all three of the major stock market indexes hit new all-time highs almost every day. Recently, more than half of the stocks in the S&P 500 reached new 52-week highs. Some market technicians are now calling the stock market “overbought.” So, it is not unusual that we, at BFS, are fielding questions from clients regarding the advisability of selling stocks or even getting out of the market entirely.

Since the S&P 500 Index bottomed on October 14, 2022, it has advanced 44.8% through April 5, 2024. More recently, since the market’s low on October 27, 2023, the S&P 500 Index is up 23.3%. Is the market currently in a worrisome “bubble”? By “bubble,” we mean a market where prices for securities or commodities are priced greatly in excess of their intrinsic value and driven by exuberant behavior.

When a “bubble” bursts, it can cause great damage to portfolios and with it, much anxiety for those caught up in it. And some of our clients have already experienced a number of “bubbles” or market crashes. A few lived through the October 1987 crash when the Dow Jones dropped 22.6% — the largest one-day percentage drop in U.S. history. And even more of our clients experienced the stock market’s long-running, sickening bear market in 2000‑2002, caused by the inflated valuations during the internet “bubble.” In the lengthy bear market that followed the bursting of the “internet bubble,” the NASDAQ Composite dropped 78% and the S&P 500 approximately 50%. More recently during the Financial Panic of 2008‑2009, the S&P 500 tumbled more than 33% during September and October of 2008. So, the intent of this commentary is to examine conditions in the stock market to see if we are currently in a “bubble” and whether investor anxiety about a “bubble” is warranted.

In contrast to short-lived cyclical bull markets, a secular bull market is one that is driven by forces that cause the prices of securities or an asset class to rise over a long period. In our view, we have been in a secular bull market since March 2009 when the S&P 500 hit an intraday bottom of 666 toward the end of the great Financial Panic of 2008-2009. Now in its fifteenth year, the S&P 500 is trading around 5,200. During this period, the stock market has performed admirably — despite periodic corrections, the COVID-19 pandemic, the riots in Washington of January 2021, the Federal Reserve’s raising interest rates dramatically in recent years, and increasing political tensions domestically and geopolitical tensions abroad. The price of the S&P 500 during this period has appreciated 677%, while the total return (including dividends reinvested) is up 941%. The chart below shows the stock market’s trajectory over the past 15 years during this powerful secular bull market:

Will this secular bull market come to an end just because it is 15 years old? Not necessarily! There have been several other secular bull markets that lasted even longer than 15 years. The bull market that began in 1949 continued its remarkable run for 17 years until 1966, when the combination of the Vietnam War and rising inflation finished it off. The bull market which President Reagan’s policies launched in 1982 and which continued until early 2000 under Presidents Bush and Clinton also lasted 17 years, when the internet bubble ended it. Some would say that the crash of 1987 divided this 17-year bull market in two, but despite the 30% sell-off during the fall of 1987, the S&P 500 still turned in a positive 2% return for the year. It should be noted, however, that there was a period of over a decade following these two 17-year bull markets where the stock market did not advance at all. The Dow Jones touched 1,000 in 1966, and in the first half of 1982, the Dow still languished below 1,000. During the “lost decade” of 2000-2009, the S&P 500 dropped -24% (although the total return, including dividends, was only down -9%).

The current secular bull market will, indeed, come to an end at some point in the next few years, but the question is when this will occur. We have quoted the German proverb before: “Die Bäume wachsen nicht in den Himmel.” This can be translated as: Trees don’t grow up into heaven. In other words, trees stop growing eventually and either fall down or are cut down. In the same way, a secular bull market eventually runs out of steam and declines.

One of the key measures in seeking to determine how the stock market is valued is the P/E ratio (price/earnings ratio). This can help determine whether the market is inexpensive, fully valued, or in a “bubble.” The P/E ratio is fundamental to valuation. The current forecast for the 2024 operating earnings of the S&P 500 is $243. With the S&P 500 trading around 5,200 (as this is written), the P/E ratio based on 2024 operating earnings is 21.4. The table below shows how the current market P/E ratio compares with market valuations over the past four decades:

There are several observations that jump out immediately. The first is the 15-fold growth of the S&P 500 earnings during this 37-year period. This remarkable growth demonstrates the engine of American democratic capitalism at work. The second is how extreme the valuation of the market was in 1999 during the internet bubble. The third observation is that the stock market’s P/E on trailing earnings has risen above 20 during the past five years. This could perhaps be a new trend, as investors are willing to value quality stocks at higher levels than previously, or a sign that the stock market has become somewhat overvalued in recent years. The chart below shows that investors have in fact accorded stocks a higher P/E ratio in the past 35 years than they did in the four decades before 1989:

It is important, however, to keep in mind the words of Sir John Templeton at the start of this commentary: “The four most dangerous words in investing: ‘This time it’s different.’” So perhaps it is not different this time. With this in mind, we want to remind our readers of another time-tested method of calculating an appropriate valuation of the stock market: the Rule of 20, about which we have written before. This rule of thumb suggests that the market’s P/E ratio should be the last twelve months’ inflation rate subtracted from 20. For example, the inflation rate in the U.S., according to the CPI statistics calculated by the Bureau of Labor, was 3.5%. Subtracting 3.5 from 20, the resulting 16.5 means that a reasonable valuation of the stock market at this inflation level is a P/E of 16.5. By this measure, the S&P 500 currently appears to be approximately 30% overvalued. The chart below shows the S&P 500’s P/E ratio since 1950 when taking into account inflation:

As can be seen from this chart, the average P/E ratio with the CPI at its current level of 3.5% is 17.5. But the current P/E ratio for the S&P 500 is 21.4 — more than 20% above the 75-year average in the chart above and 10% greater than the average P/E ratio since the fall of the Berlin Wall.

We have written before about the so-called “Magnificent Seven.” These seven stocks — Microsoft, Alphabet (Google), Meta Platforms (Facebook), Apple, Nvidia, Amazon, and Tesla — have had a disproportionate effect on the S&P 500. For example, the Magnificent Seven had a total return of 70% in 2023, while the remaining 493 stocks in the S&P 500 were only up 11.2%. In the same vein, the P/E ratio of the Magnificent Seven for the next 12 months earnings is 30.7; the P/E ratio for the S&P 500 median next 12 months earnings is only 19.0, according to Strategas. So, the overall stock market is trading at a less expensive P/E ratio than are these seven stars.

There is another influence which has caused the stock market to be somewhat bifurcated: Artificial Intelligence (AI). Last year, we wrote an entire investment commentary on AI, describing both traditional (or computational) AI and generative AI. It is not our intention to repeat what we wrote in our July 2023 investment commentary. But if there appears to be a “bubble” in the market currently, it is because of AI. Earlier bubbles occurred because of the advent of a life-changing new technology such as the internet or the railroad. Many market observers and investors believe that AI is a similar sort of game changer. And this belief has elevated the market value of many companies which either manufacture products that create generative AI (like Nvidia) or maintain that they have adopted AI in their businesses (like Meta Platforms and Adobe). Below is a sampling of companies that fall into these two categories:

There are many differences between the current stock market and the market at the time of the internet “bubble.” The first and perhaps the most important is that at the turn of the millennium, there were a great many companies trading on the stock exchanges which had neither significant revenues nor profits. In those halcyon days, the mere mention of internet, web, or dot-com was enough to cause investors to pour money into a stock. It was truly the Dutch tulip bulb craze of the 17th century transported to 1999-2000. Conversely, all of the companies listed above are mature companies with strong business models and robust earnings and cash flow. Moreover, most of these companies are not only growing their earnings at double digits, but many of them are projecting earnings growth of 25-35% over the next few years. This means that the PEG ratio (P/E ratio divided by the EPS growth rate) varies between 1 and 2 — very sound ratios for quality growth companies. For example, Nvidia is projected to earn $22.63 in 2024 — up from $12.14 in 2023 — which translates into an 86% growth rate. In these circumstances, a P/E ratio of 37, while seeming to be stretched, does not appear so in light of the forecasted earnings growth. Accordingly, Nvidia may be appropriate for aggressively structured portfolios.

At the height of the internet bubble in 1999/2000, the P/E ratios of many of the top companies were ridiculously expensive. For example, Cisco’s stock price peaked at $80 with a P/E ratio of over 200. The stock fell 89% over the next several years. The price of another market favorite — Yahoo — peaked at $118 with a P/E ratio of over 800. The stock subsequently fell 96%. The P/E of even that great stock market stalwart, Microsoft, was 73 when the stock peaked at $54 a share in 2000. The stock then fell 72% and took almost 15 years to regain its price at the peak.

In summary, we do not believe that the stock market is currently a “bubble.” Certainly not like it was in 1999-2000. But, we do believe that AI is an historic new technology, and investors should own stocks in leaders in this field, albeit only at reasonable prices. But there are flashing signs that some degree of caution is appropriate. As mentioned above, the current secular bull market has been running for over 15 years, and it is only two years away from the two longest bull markets in the past 75 years. Markets do not advance forever.

While there are sectors in the stock market where one can still find good values, the broad stock market is certainly fully valued and perhaps even moderately overvalued, with the S&P 500 priced at 21.4 times 2024 operating earnings. At this level, the earnings yield of the S&P 500 is 4.65% (earnings divided by the price of the S&P 500). The current yield of the bellwether 10‑year U.S. Treasury Note is 4.57%. When one compares the earnings yield of 4.65% with the current yield of the 10-year U.S. Treasury Note at 4.57%, there is almost no equity risk premium, which is another warning sign for the stock market.

The current market valuation leaves little room for error or surprises. And there are certainly problems aplenty around the world, starting with the current Presidential election in a fiercely polarized nation. Geopolitically, there are worrisome conflicts with the Russia-Ukraine war and Israel/Hamas as well as tensions over Taiwan. In each of these situations, one fears that unintended consequences could send things spiraling out of control. But on the positive side, the stock market has advanced positively in every Presidential election with the incumbent running since 1944, and this should give us some comfort about the trajectory of the market this year. May history repeat itself.