Dow Tops 16,000: Are We in a Bubble?

bubblesOn Monday, the DJIA reached the 16,000 mark. Another record. And another flurry of news articles about potential bubble trouble.

There are plenty of reasons for caution. So far, the rise that started in the stock market in March 2009 has lasted 56 months and produced gains of 166%. Margin debt has risen to record levels, investor sentiment is quite upbeat (55% bullish and only 16% bearish) which often foretells a correction, and warnings are coming from the likes of Warren Buffet and Carl Icahn.

Let’s put this in perspective. The S&P 500 is valued at 16 times projected 2013 earnings and 15 times estimated 2014 earnings. According to Barron’s report on Saturday, those price/earnings (P/E) ratios are about equal to the long-term average. Equities are currently trading at 2.5x book value- far below the peaks of prior bubbles. P/E ratios were 23, 30, and 17.5 before the bubbles popped in 1987, 2000 and 2007.

Perhaps a better measure for valuation other than P/E is CAPE. CAPE or cyclically-adjusted-price-earnings ratio is the brainchild of recent Nobel Prize winner Robert Shiller. Instead of focusing on one year of earnings, it averages the past 10 years, and adjusts them for inflation using CPI. Inflation is a powerful force that is often ignored when looking at nominal all-time highs. Dr. Shiller used CAPE valuation in his book “Irrational Exuberance” published in March 2000 which demonstrated how markets were overvalued during the internet boom. The dotcom bubble burst the same month.

Today, CAPE is at 24. The long-term average is 16. Dr. Shiller cautions against using CAPE to time crashes and make short-term trades. Rather, CAPE is more useful in predicting longer-term returns. Looking at stocks today, Dr. Shiller recently said: “The market is somewhat high, but it’s not a time when I would be writing ‘Irrational Exuberance’”. He continued: “Stocks are merely expensive, rather than bubbly.”

What Dr. Shiller does say, though, is that high CAPE historically produces lower returns in the following three years than years following low CAPE amounts. That’s understandable- it’s the old “reversion to the mean”. Good to reflect upon after such a banner year in stocks in 2013.

Perhaps a better question to ask, other than “Are we in a bubble,” is “Am I comfortable with how my portfolio would perform if there is a significant correction in stocks?” As we pointed out in our seminars last month, it’s all about stress testing your financial plan and your portfolio and focusing on what you can control.

Let’s say you have a balanced risk profile and have an asset allocation of 50% stocks, 25% fixed income and 25% alternatives. If there is a 15% stock market correction, what will be the likely short-term impact on your portfolio? Based upon what happened in 2008, the impact might be a decline of 5%-10%. Of course, past performance is no guarantee of future results. Can you live with such a decline? The answer should be yes for someone with a balanced risk profile.

We can’t tell you whether we are in a bubble or not. We do watch the markets very carefully but we can’t control them. What we focus on is making sure every client’s asset allocation is consistent with their risk profile. We also focus on the components within each asset class, rebalancing the investments on a systematic basis in an effort to produce enhanced performance. That’s the way we protect and grow our clients’ net worth and legacy and give them peace of mind.

Valuable Insights from Nobel Prize Winners

Nobel prizeLast week the Nobel committee awarded Eugene Fama, Robert Shiller and Lars Peter Hansen the Nobel Memorial Prize in Economic Science. At first, it would seem that Drs. Fama and Shiller make for a very odd couple. Dr. Fama believes in efficient markets while Dr. Shiller argued that the stock market in the late 1990’s and U.S. house prices in the early 2000’s were the result of “irrational exuberance.” Yet, there are valuable insights to learn from both Drs. Fama and Shiller.

Dr. Fama’s was that, because relevant information is quickly incorporated into asset prices, professional fund managers are unlikely to beat the market. His research followed that of another Nobel laureate, Paul Samuelson, who in his 1974 essay demanded “brute evidence” that active money managers could beat the market index. Such evidence has not been found. Dr. Fama’s work led to the development of the index-tracking industry. This allows investors to diversify their portfolios at low cost. Dr. Fama inspired the founding of Dimensional Fund Advisors (DFA), which follows an indexing strategy and exploiting market anomalies. Some DFA funds are used by DWM for portions of our equity and fixed income holdings.

Research of vast statistical evidence has shown that returns earned by active managers seldom outpace the S&P 500 index. Further analysis showed that the failure of active managers was the result of the costs they incurred. As John Bogle, founder of Vanguard puts it: “The average manager is only average, but only before these fund operating expenses, advisory fees, turnover fees and sales loads. After those costs, active management becomes a loser’s game (for equities).”

Dr. Shiller has always been a skeptic. His basic theory has been that financial assets are unlike consumer goods- when their prices rise, that creates more demand, not less. He believes that it is no use hoping that “rational” investors will drive prices back to fair value. Dr. Shiller is a professor of economics and Yale and his wife is Dr. Virginia Shiller, a clinical psychologist in private practice in New Haven. Back in the 1980s, Dr. Robert Shiller became the founder of the field of behavior finance, incorporating psychology into economics, particularly looking at bubbles in stock and real estate markets.

Dr. Shiller was one of the founders of the Case-Shiller Index, which measures real estate prices. He also developed “the Shiller P/E” which uses price and earnings to measure whether the stock market is overvalued. He predicted the dotcom bust due to a “Shiller P/E” of 44 as compared to a long-term average of 16. He predicted the housing bubble in 2006 citing the fact that house prices rose by 7% in real terms from 1890 to 1997 and then by 85% between 1997 and 2006.

Dr. Shiller’s work was used by DWM in early 2008, when we issued our “Bubble Bust Report” for clients and helped them reduce their equity positions and start to use alternative investments to better protect their portfolios. Like Dr. Shiller, we are cautiously optimistic at DWM.

The NYT interviewed Dr. Shiller last Sunday and asked him about his relationship with Dr. Fama. I thought he had a great response. He said, “Well, Gene and I have a lot in common, more than you might think. I use many of his theories. Not all of them, of course. But he’s a very good guy. It’s like having a good friend who is a devout believer in another religion. You can learn a lot from a friend like that, even if you don’t pray in his church.”