Are We in a Bubble? Is the Market About to Crash?


September 18, 2017

Like many investors, you may be wondering if we’re in a bubble and how to figure out if the market is about to crash. There’s no shortage of articles out there taking one stance or the other. And yes, we are going to add to the pile and take our stance.

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

So here’s the truth: we guarantee that you will lose money at some point if you are invested in the stock market. The market goes up and down. That is reality. But looking at the alternatives, we believe your best plan is to stay in the market. Why? Because when you stay on the path, you also benefit from the recovery when the market rises.

Patience and staying on the path sound good until the market starts dropping – or running up. When your $500,000 becomes $400,000, your reality shifts. Your savings just shrunk, and opinions no longer matter. Emotions are real, and they influence investment decisions. But if you decided to pull out or sit out of the market as the Dow approached and then moved beyond 20,000, then you missed out on a 10% market rise in a fairly short period of time1.

“The stock market is a device for transferring money from the impatient to the patient.” – Warren Buffett

You might look to financial gurus like Warren Buffett and wonder if our advice of staying in the market is valid. Warren Buffett currently has about $100 billion in cash (or 25%). Is he staying out of the market? Not at all. He carries so much cash because the magnitude of his purchases makes it harder to execute a buy without influencing the market or unintentionally taking majority share of a company. He has to be extremely selective for that reason. For our clients’ investments, we traditionally keep about 2-10% of the portfolio in cash, but that is only to give flexibility to make purchases when we see good deals. We operate using a philosophy similar to Buffett’s, but our smaller scale gives us the flexibility to make purchases he can’t.

In short, we believe:

  • Bonds are currently overpriced
  • Cash isn’t a great alternative
  • This market has different characteristics than other markets that were considered bubbles

We interviewed Chris Creed of AFAM Capital for this article to learn more and got some detailed answers to our questions. Click on any of the questions below to jump to the answer.

Are we in a bubble? Should we move to bonds?

Are bond prices linked to stock prices? Or are they independent?

What happens if I have money in the stock market now, and it’s just getting ready to drop, or crash? Or do I need to get my money out of the market before it’s too late and the party’s over?

What did Mark Hulbert mean when he wrote that your unique differentiator is your ability to stay in the market when everybody else is pulling out – even a lot of your peers?

“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” – Peter Lynch

You are not the only one worried about the market response to major events. Go in prepared with insights from data.
Download Free Market Report

Question: Are we in a bubble? Should we move to bonds?

Chris: We don’t think we’re in a bubble. Prior bubbles have been preceded by what Alan Greenspan called irrational exuberance. You’ve got the tulip mania2, you’ve got the tech bubble, there was the housing bubble; there have been a variety of them throughout the years. But a bubble usually is precipitated by investors throwing money into things that were clearly overpriced. Where we are right now, we don’t think traditional measures are necessarily being applied like they should. What I mean by that is people would say the stock market is at an all-time high. Well the stock market was at an all-time high a few years ago as well. But what we don’t have now is an alternative to stocks in terms of attractive yields.

This fixed income market, the bond market, is also at a high. It has been exhibiting historically low-yield, which means the prices are at 35-year highs right now, roughly. So there is no alternative. In the prior bubbles there has been an alternative for money to flee out of the stocks, and there weren’t things that were supporting the stock price. In the tech bubble a lot of these tech companies had lots of revenue, but they didn’t have any earnings. There were no profits for the companies at all. Right now corporate earnings are pretty healthy. In fact, just a week ago when they measured the earnings for the current quarter for S&P 500 companies, 72 percent of them had exceeded analyst expectations based on their earnings projections3. So we don’t think we’re in a bubble. That doesn’t mean we can’t have a correction somewhere along the way. But by traditional measures, we don’t think we’re there.

Question: Are bond prices linked to stock prices? Or are they independent?

Chris: Not exactly. We know people think of bonds as not correlating with stocks, but that’s not entirely accurate. Sometimes they move together. Bonds are considered a safe haven for money by a lot of people. When people pour their money into bonds or fixed income, it drives the prices up. So what happens is their yields go down. If bond prices go up, the yields go down. If you’re buying a five percent bond for $10,000, you’re getting $500 for your $10,000 investment. If interest rates, and therefore the bond price goes up, you pay $11,000 for that five percent bond. You’re still getting $500, but you had to invest $11,000 to get that same rate of return.

So to answer your question – no, bonds and stocks don’t necessarily move in lockstep. Bond yields will tend to go up with an economy that is heating up. The Fed will raise rates to try to cool the economy down, but so far the raising of the rates has been very slow, so bond yields are still historically low right now. For example, a ten-year treasury yields less than two-and-a-half percent right now4, which is very low. It has been around the five- to six-percent range historically5.

Question: What happens if I have money in the stock market now, and it’s just getting ready to drop, or crash? Do I need to get my money out of the market before it’s too late and the party’s over?

Chris: When thinking about that question, I think of this quote by Charlie Munger who is Warren Buffett’s partner, “Don’t just do something, stand there.” It’s the idea that a lot of activity is not necessarily consistent with good market results. If you look at John (Buckingham)’s record, and you tack on Al Frank’s record, we have participated in 100 percent of the down markets6. Meaning we never moved to cash. We might have had up to ten percent cash, but we’ve never moved out of the market. Why is that? Let’s assume we’re pretty good at anticipating companies’ profits, and we’re pretty in tune with what the economy’s doing. Why wouldn’t we move out of the market? It’s because we don’t think there’s any advantage to be gained. We think equities are long-term investments. There’s no warning light for trying to time when to get in or when to get out. There are many people on TV saying the market’s at a top, it’s about to go down in the near term, you hear those projections enough. But by and large, they’re wrong. We just don’t think we can time it well enough.

For example, if you put money into the market right now and it drops six months from now, would that be awful? Yes. But in rolling periods, the vast, vast majority of rolling 10-, 15-year periods, you made money in the stock market. Think if you went to the horse races and they said, look, you’ve got a 95, 98 percent chance of making money. You’d take that bet all day long. We think that’s the stock market as a long-term investment. You’re never going to get the timing right on when to enter, or when to exit. The probability of making money in a diversified portfolio of equities held for the long term is extremely high. So we don’t try to time it at all.

Question: What did Mark Hulbert mean when he wrote that your unique differentiator is your ability to stay in the market when everybody else is pulling out – even a lot of your peers7?

Chris: When you look at our newsletter returns versus our peers, the ones that have tried to time it, in general we’ve got better returns. So we’ve ridden through the pain, and still come out the other side with better returns. Part of how we do that is to take the emotional aspect out of it. You look at us and we’re very disciplined, and we stay true to what we do, which is staying fully invested. If we had to try to guess when to get in and get out, emotion could play into that. I say guess because there’s no certain indicators of a downturn. People tend to not get out at the top of the market. People tend to get out when the market has sold off some, and they’re starting to feel scared.

What they say they will do is get back in when the market is at its bottom. But what they really do is get back in when they feel better about the market. When do they feel better about the market? When the market has made some headway, and has gone back up again. So the net effect of them jumping out and jumping back in generally didn’t do very much for them. A lot of times it actually made the situation worse. We’ve seen it where people have gotten out when the market was down, and then got back in when the market was up. So they’ve actually ended up with bond-like or even worse returns, but they took equity like risk. They’ve essentially taken all the risk of the equity market and made it worse for themselves by trying to make arbitrary timing decisions.

“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.” – Peter Lynch

You are not the only one worried about the market response to major events. Go in prepared with insights from data.
Download Free Market Report

1 Between January 25, 2017 and September 18, 2017, total returns for the Dow Jones Industrial Average Index were 11.27%. Bloomberg Finance.

2 https://en.wikipedia.org/wiki/Tulip_mania

3 As of September 12, 2017. http://lipperalpha.financial.thomsonreuters.com/wp-content/uploads/2017/08/TRPR_82201_20170912.pdf

4 As of September 19, 2017

5 Mean 10 Year Treasury rate between January 1, 1871 and September 18, 2017 is 4.58%. http://www.multpl.com/10-year-treasury-rate

6 March 1977-September 2017

7 http://webreprints.djreprints.com/53306.html

Nothing presented herein is, or is intended to constitute, investment advice, nor sales material, and no investment decision should be made based on any information provided herein. The information provided herein is educational in nature, is not individualized, and is not intended to serve as the primary basis for your retirement, investment, or tax-planning decisions.

No guarantee of investment performance or dividend payment is being provided and no inference to the contrary should be made.

Investing involves risk, principal loss is possible, and there can be no assurance that investment objectives will be achieved. The information presented herein is for discussion and illustrative purposes only and does not constitute investment advice. It is not a recommendation or an offer or solicitation to buy or sell any securities.

Information provided reflects AFAM’s views as of a particular time. Such views are subject to change at any point and AFAM shall not be obligated to provide notice of any change. While AFAM has used reasonable efforts to obtain information from reliable sources, we make no representations or warranties as to the accuracy, reliability or completeness of third party information presented herein.

296-AFAM-9/27/2017

 

 

 

 

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