Is the stock market a bubble?
The answer to this question is a big deal for the approximately one-third of well-to-do Americans who own most of the stock. However, it also matters to the broader economy and thus by extension to the majority who don’t.
All of the ingredients that go into making a bubble are evident. Most important, stock prices have been on a tear. Prices never move in a straight line, but they’ve rocketed more or less straight up over the past decade, more than doubling since the COVID-19 pandemic.
This amount of price growth has happened in only three other decades since the late 1800s, when the Dow Jones Industrial Average index, comprising the 30 largest publicly traded companies, was first published. Those decades were the 1920s, the 1950s, and the 1990s.
The roaring 1920s, of course, ended terribly in the 1929 stock market crash, which ushered in the Great Depression of the 1930s. That was clearly a bubble.
In the 1950s, stock market gains were powered by U.S. companies’ dominance of the global economy after World War II. This included companies such as General Electric, AT&T, General Motors, U.S. Steel, and DuPont. That wasn’t a bubble.
And then there was the 1990s internet craze, which ended soon after Y2K with a dramatic decline in stock prices. No question: That was a bubble.
The internet was a game-changing technology that resulted in enormous productivity gains and ultimately generated significant profits. However, investors had discounted all this and much more. Stock market valuations — stock prices relative to corporate earnings — surged.
Valuations aren’t quite as lofty today as they were in the late 1990s, but they are close. And they are still on the rise. My favorite valuation measure is the ratio of the value of all publicly traded stocks, as measured by the Wilshire 5000, to economy-wide corporate profits from the Bureau of Economic Analysis.
In the 75 years for which this valuation measure can be calculated, stock prices have averaged 12 times corporate profits, a 12-1 ratio. Currently, the ratio is 20-1. The only other time valuations have been higher was at the height of the Y2K bubble, when the measure briefly spiked to 24-1.
But perhaps today’s extraordinary stock market valuation is justified. After all, this largely reflects the investors’ optimism about the large artificial-intelligence companies. These so-called hyperscalers are nothing like many of the fly-by-night internet companies (think Pets.com) that inflated the Y2K bubble.
This is undoubtedly the case, but like those internet companies, the stock prices of today’s AI companies are being juiced up by investor speculation. That is, an increasing number of investors are piling into these stocks, driven by the simple logic that since their prices have risen a lot, they will continue to rise. This momentum will continue, and if it doesn’t, they will be smart enough to recognize this and find other unwitting investors to buy their stocks before the bottom drops out.
Another form of arguably accidental speculation may also be taking hold in the stock market via the fast-growing index funds. These funds passively track a market index, like the Standard & Poor’s 500, by holding stocks in the same proportion as the index. The goal is to match the market’s performance. Index funds offer the benefits of diversification and low fees but aren’t based on an analysis of the underlying companies’ strengths.
Thus, if the stock price of a company is rising, it will attract more investments from index funds, and its price will rise even further. There is no argument that AI-chip juggernaut Nvidia’s stock price should be up significantly, for example, but it has increased substantially more due to this self-reinforcing dynamic.
The soaring stock market has been a powerful tailwind to the entire economy.
The wealthy, who own the bulk of the stocks, are now much wealthier and spending accordingly. In the past year alone, stock wealth has increased by nearly a staggering $10 trillion. This newfound wealth supports a significant amount of spending, which, in turn, supports a substantial number of jobs.
This brings into clear relief a significant threat to the economy. If the stock market is a bubble and it bursts, wiping out this wealth, consumer spending will suffer a significant blow, triggering a recession. This is precisely what happened after the bursting Y2K bubble.
So, is the stock market a bubble?
Well, if it isn’t, it soon will be if the current trends continue for much longer. The final ingredient for a bubble is that nearly all the naysayers are silenced. That happens when they’ve called out the bubble for so long, they are no longer considered credible. Any skepticism is thrown to the side, and the bubble inflates more.
We aren’t there yet. There are still too many naysayers like me.