Big Fat Bubble
If you pay attention to most of the popular investment sites or T.V. shows you might have noticed some conflicting messages. You’ll have one jerk argue that “things are different” and that we will continue to see stocks rise. Then another jerk, on the same day, will argue that we are way overdue for a recession / stock crash.
This is actually kind of a smart tactic because you win either way and you attract readership / viewership based on two key psychological drivers; namely greed and fear.
If you bring on guests that think stocks will go up and then bring on other guests that say stocks will go down, you get to have the best of both worlds and cover both potential outcomes.
Do you think they could get away with that on the weather? I guess they do. There is a fifty percent chance that it will rain tomorrow. Then when no rain happens they aren’t really wrong. Seems like a nice scam!
So as we get closer to meeting our objective of accumulating enough wealth to support our everlasting world vacation dream, we do worry that we might be in a “big fat bubble”.
The FEAR side of our brains is telling us that we are overdue for a recession. Think about it for a minute. The business cycle has always existed; boom and bust, boom and bust. Yet we are approaching the longest growth period without a recession in the history of the US stock market. So that should mean that we are pushing the limits before the next recession and stock sell off; right?
It does feel like stocks are expensive but what does that even mean for stocks to be expensive? After all isn’t a stock’s price equal to what someone is willing to pay for it? I guess a good place to start when evaluating “how expensive a stock is” would be by looking at the Price to Earnings Ratio (P/E Ratio).
Let’s bring in Professor Dictionary again for one more cameo appearance. Take it away:
The market price divided by the earnings per share. The higher it is, the more expensive the stock is. The lower it is, the cheaper the stock is. When looking at an index, you can usually lookup the blended P/E ratio for all of the stocks.
The S&P P/E ratio is about 25 right now. The ratio typically ranges between 15 and 35 if you look at the last few decades of history. This does suggest that stocks are approaching “expensive” territory.
Now, let’s travel back in time for a minute to see what history can tell us about what this could mean:
- Before the 2001 tech bubble burst: P/E ratios for S&P were above 30.
- Before the 2008 financial crisis: P/E Ratios for S&P were above 27.
Well that doesn’t feel so great. So should we follow the old advice of buy low and sell high? It feels like we are approaching a “high” yet we are continuing to break records as of the writing of this article.
Shouldn’t we take our money off the table and lock in our gains now?
Well with this line of thinking we would have taken our money off the table last year. We felt we were already in an overvalued situation but we held true to our plan which is to ride out all the waves. If we had switched to cash a few things would have happened.
- We would have had to pay capital gains taxes which would have eaten away at some of the gains.
- We wouldn’t have played in the rally that occurred this year. Stocks have gone up 13% since the beginning of the year. We would have lost out on over $100k in investment appreciation and all the quarterly dividends along the way.
Remember, our strategy isn’t to pick individual stocks. Rather we invest primarily in low expense index funds. By investing in the largest companies in the US and in the world, we are investing in civilization as a whole. We aren’t smart enough to pick the individual winners and losers but we trust that smart people will start new companies that will change the world for the better. We want a piece of that action, and by investing in the large indexes we get them when they become big enough to matter.
To us, what we do before the next bubble burst doesn’t matter. It’s what we do AFTER the burst that matters. During a financial crisis there is usually tremendous emotional pressure to “get out of the market because the world is ending” or at least it feels that way when it is happening. When people do that, they end up missing out on the next boom. For example, If you sold right after the 2001 crisis you would have missed out big time. Check it out:
- 2001 tech bubble: Nearly fifty percent of the value was lost in nine months. The market did recover, but it took a long time: 15 years.
- 2008 financial crisis: Over fifty percent of the value was lost in a year and a half. The market also did recover but this time it took 5 years.
These two major events scare lots of people away from the market and that’s understandable. When I see articles suggesting that Millennials aren’t investing, it makes perfect sense to me. They formed their opinions on the market in their early adult lives while observing and living through two major crashes. There is risk here since it may take years before the markets return to their highest level after the next major selloff but remember there is also risk in staying on the sidelines in cash such as:
- Inflation will eat away at your savings
- You miss out on the dividends
- If you aren’t contributing to a 401K, you are missing out on the tax benefits and employer matching.
It’s not like you throw all your savings in on one day. Most people make contributions over time so there is a smoothing effect of the net gains / losses.
We know an event is coming. We don’t know what it is or when it will happen.
All we can plan for is our response when it does come. We are prepared to not pull it out when that happens and ride it out for as many years at it takes.
Our early retirement plan is built around only living off of the dividends. If the principal (number of shares) is untouched, then the price of the shares matters far less than the constant dollars we receive from dividends of those shares.
If you are invested, what will you do when the next crash happens?