It’s well-established that the stock market swings between periods of under-valuation and over-valuation. One of the most critical decisions any investor must make is what to do when the market is in an over-valued state. For those who are fortunate enough to be young, and therefore have many years of saving and investing ahead of them, this is not something to worry about – unless the market becomes so over-valued that it starts to resemble Crazy Town, as it did in 2000, 2007, and 1929. Those were clearly stock market bubbles. We are now in the early stage of a new one.
For the rest of us who have been in the game for a while, and are looking at a shorter time frame than someone who is just starting out, the issue of valuation becomes more serious. This article is intended to be a cautionary note, but it’s not a market-timing call or a recommendation to head for the exits. Markets often spend months, or even years, in an over-valued state. Most major stock market crashes happen after long periods like this. What starts out as a new bubble becomes a bigger bubble, then a huge bubble, and finally a divorced-from-reality bubble. We are in the early stages of a bubble now, and not the late stages.
One of the indications that we are in the early stages of a new stock market bubble is the fact that it has been so long since the last correction. A correction is a price decline of 10% in the market. The last one happened way back in October of 2011. That makes this the 2nd longest stretch without a correction since World War II. The longest uninterrupted bull run was from October 1990 to October 1997.
Does the fact that it’s been so long since our last correction mean that we’re “due” for one? No. Look at it this way. If you flip a coin and get heads ten times in a row, your odds of getting heads on the 11th flip are still 50-50. It’s the same with the stock market. It could continue to go up for another year, or even two, before we get a 10% pullback. But the fact that it has been so long since the last one, combined with many indications of over-valuation, means that the risk of a correction are higher than they would otherwise be.
Bubbles can be corrected in one of three ways. The first, and most difficult to deal with, is a crash followed by a bear market. This happened in 2008, 2000, and 1929. I don’t expect it to happen in 2015, but if this bubble continues to inflate at it’s current pace, a crash could happen in 2016.
The second way to resolve a stock market bubble is by having the market go sideways until the economy and corporate earnings catch up to stock prices. This happens often, and it’s more likely than a crash. If the market goes sideways for the next year, we can avoid a crash as the economy continues to heal from the Great Recession of 2008.
The third way to resolve a bubble is for the economy to enter a “boom” phase, where growth accelerates and corporate earnings begin to rise sharply. The trouble with this scenario is that it usually comes with lots of volatility in the market. The volatility is caused by the Federal Reserve and the policy makers in congress, who can’t resist the temptation to meddle with interest rates and fiscal policy. As the Fed begins to raise interest rates in an effort to “cool things off,” the policy makers start pushing for austerity in the form of cutting back on government spending in order to reduce the national debt and balance the budget. These actions typically cause fear and loathing among the biggest class of investors – the giant pension funds, global asset allocators, and sovereign wealth funds.
Any way you slice it, we are headed into a period of adjustment in the market. We’ve enjoyed more than six years of a bull market, and we might be able to squeeze another year or two out of it before the inevitable and painful process of correcting the excess valuations begins in earnest. So my recommendation is to stay in the game for now, but keep one eye on the exits at all times. The ride is about to get a little bumpy.