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Investors: Don't Fall for the Stock Market Bubble Strawman


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Stocks are higher on Wednesday morning and could be looking at a new closing high, with the benchmark S&P 500 (SNPINDEX: ^GSPC) and the Dow Jones Industrial Average (DJINDICES: ^DJI) (DJINDICES: $INDU) up 0.54% and 0.33%, respectively, at 11:30 a.m. EDT.

Don't fall for the stock market bubble strawman

The Financial Times ran a thought-provoking piece this morning titled "Read some history before screaming US stocks are in a bubble." The author, Miles Johnson, argues that, despite the warnings of authorities ranging from investment bank Goldman Sachs to Nobel prize-winning economist Robert Shiller via legendary investor Carl Icahn, U.S. stocks are not in a bubble.

Johnson refers to the example of the late 1960s, early 1970s fad of the "Nifty Fifty" -- a group of blue-chip growth stocks such as Disney, Philip Morris, or Coca-Cola that were thought to be "one decision" stocks (i.e., you need only buy them, no questions asked, as it were). According to data from Professor Jeremy "Always Bullish" Siegel, if one had bought the Nifty Fifty at their 1972 peak, they would have suffered only a sliver of underperformance relative to the S&P 500 through 1996, with an annualized return of 12.7% versus 12.9%.

Johnson concludes that "[t]he moral of this is not that all stocks should be bought at any price. Instead, a long-term purchase of a strong business at a reasonable price should reward them. It may be unfashionable to say, but many excellent businesses are still on offer for prices that are not screaming a bubble.

It's entirely true that financial journalists, strategists, and other pundits make liberal use of the b-word -- "bubble" (I have been guilty of this myself). This is partly the nature of punditry: You need to make bold, even strident statements if you want to capture people's attention in a world that is drowning in information and commentary (much of which is poor quality). In that context, "overvalued" quickly becomes "in a bubble," even though the two are absolutely not synonymous. A bubble requires asset prices to become completely unhinged from underlying fundamentals, leading to gross overvaluation.

In an environment plagued by exaggeration, misinformation, and misunderstanding, it's worth trying to try to introduce a bit of rigor into the discussion. For the statistically minded, bubble-watcher Jeremy Grantham of the eponymous company GMO (the G stands for Grantham) uses a standard-deviation event as the minimum requirement for a bubble. ("In a normally distributed world, a 2-sigma event would occur every 44 years.") It turns out that Grantham has a few things to say on the "Nifty Fifty" (emphasis added):

The six most important asset bubbles in modern times qualifies on the 2-sigma definition, although the 1965-72 peak, known in the trade then as the "Nifty-Fifty" event, did so by a modest marginThis event fell short in providing the usual good examples of extreme investment craziness. Perhaps, though, the very definition of the Nifty Fifty as "one decision stocks" may have qualified it ... for "one decision stocks" were so named because you only had to make one decision: to buy.

Note that, according to Grantham, the "Nifty Fifty" barely cleared the bar to qualify as a bubble. Furthermore, it is an example that must be treated with caution since the group of stocks were (for the most part) among the greatest American businesses ever, with a huge growth runway still ahead of them.

Denouncing cries of "bubble" in the current market to support the notion of buying stocks is a bit of a strawman. Those who say U.S. stocks are now in a bubble are wrong, but -- and it's a crucial "but" -- that doesn't preclude stocks from being overvalued, which they are. Buying overvalued stocks doesn't imply disastrous future performance, but it does suggest future (long-term) returns from current levels will be mediocre compared to historical returns. That's the risk investors face today, and it is manageable -- but only if one is willing to admit the risk is genuine.

Tweet(s) of the Day

It always ends badly. Every single time. Nature of markets. Game is to approx guess how/when. 7yrs too early = lose

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Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.