Are Stocks in a Bubble?

Everybody’s getting excited about stocks these days. Maybe a little too excited?

The S&P 500 is near all-time highs. Speculation is heating up. Elon Musk is now richer than Jeff Bezos. Carole Baskin (of “Tiger King” fame) is peddling penny stocks. We’re glad markets are doing well, but this environment feels a little uneasy.

There’s a worry that the stock market may be overheating, and the pot may be close to boiling over. Google search trends for “stock market bubble” and investor optimism are at their highest point in years.

So, are stocks in a bubble? We don’t think the market is in trouble, but the air does feel a little thin for some of the high flyers.

What’s a bubble?

In markets, there can be too much of a good thing. When the prices of investments or assets rise quickly to levels that exceed what they are worth based on fundamental traits (earnings, cash flow, historical valuations, etc.), the risk of those investments or assets rises. Wall Street calls this situation a bubble.

Turning a blind eye to this level of risk works until bad news that can’t be ignored happens. Then, investors rush for the exits en masse, leading to a dramatic drop in prices. Think of it like blowing up a balloon: You can fill it with more air, but it’ll eventually pop. Typically, bubbles form in periods of high economic growth fueled by easy, low-rate money sloshing around in the financial system.

Bubbles can appear anywhere, too. The most notorious was the early 2000s tech bubble, in which the Nasdaq more than doubled in 12 months before plunging 80%. The Great Financial Crisis started with a bubble in housing prices. There was even a tulip price bubble in Holland during the 1600s.*

*True story. Look up “tulip mania.”

Bubble Signs

Now that we know what a bubble is, it’s clear why people are getting concerned.

Some areas of the market look a little bubbly. Here’s why:

A fast rally: Stocks’ rally has been especially quick lately relative to history. The speed has pushed the S&P 500 to 15% above its 200-day moving average, around the widest spread since 2010. When the spread reached similar levels back in September, a near-10% correction occurred in the market.

Speculation: Investors are flocking to riskier areas of the market. Cult stocks like Tesla have gripped the market’s attention. The stock continues to grind higher despite plans to issue more shares (typically a negative for a stock’s price). The initial public offering (IPO) market just capped its busiest year in recent memory, partially because of a new boom in special purpose acquisition companies (SPACs).

IPOs that began trading this week kept the celebration going: Poshmark popped 141% on its debut, and Affirm was up 98%. Plus, over-the-counter “penny stock” volume has spiked. These stocks typically are harder to trade (i.e., they have less liquidity), making them riskier investments.

Other markets: There are even signs outside of stocks. Bond yields are climbing. Home sales have jumped to 14-year highs. Options investors are trading more calls than ever before. Cryptocurrency prices are soaring.

Too soon?

There are red flags popping up, but it may be too soon to call the top. Why?

The Fed: History has taught us that the number one way to pop a bubble is through the Fed raising rates. Every bear market in recent history has been preceded by interest rate hikes.

Take the tech bubble. In the year before the top (March 2000), the Fed raised interest rates from 4.75% to 6% to tame an overheating economy.

This time around, rates are historically low after two big cuts last year, and the Fed has vowed to keep them low for the foreseeable future. Fed Chair Jerome Powell doubled down on that stance this week. While the economy is rebounding, inflation has remained well below the Fed’s expectations. We expect inflation won’t force the Fed to move rates this year.

The market’s makeup: Check under the hood, and the market looks different than its tech bubble days. Over the past few months, we’ve seen a shift into slow-and-steady value stocks, while big tech stocks have taken a step back. As evidence, the S&P 500 Equal Weight Index has outperformed the S&P 500 by more than nine percentage points since September 30. A change in sector leadership could keep the market afloat, while the froth is deflated from speculative areas.

Earnings: If that isn’t enough, worries about valuations could be overblown. The market’s price-to-earnings ratio (P/E) is high at 23x, but earnings are catching up quickly. There’s also a good chance Wall Street is underestimating earnings growth in 2021. Earnings estimates for this year continue to climb, and companies continue to beat estimates handily. As the year progresses, we expect the P/E ratio to moderate.

Is this the top?

Most bubbles are only bubbles in hindsight. At this time, we remember the popular phrase “don’t fight the Fed.” With the Fed squarely in a holding pattern, we don’t foresee them popping bubbles in the near-term.

We are also hopeful investors tired of paying stretched prices/valuations will continue to rotate into parts of the market that offer greater (and perhaps more reasonable) opportunity. That could result in an orderly unwind of some potential bubbles, allowing this bull market to keep calm and carry on.

Lindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. She is also President of Ally Invest Advisors, responsible for its robo-advisory offerings. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.