When you look at price-based measures, over the past several years they have been consistently at or well above historical levels—and that premium has grown further as interest rates declined. Even in times of market stress, valuation lows have still held at or above levels that were highs in history. The fact is, we are now living in a higher-valuation world, which makes the historical price comparisons less relevant.
What If Sentiment Changes?
Looking at this analysis, we can conclude that current valuations, while high, are not necessarily unsustainable and not driven solely by investor sentiment. Which brings us to the next part of the bubble question, which is whether prices will inevitably drop once sentiment changes. Since a large part of what appears to be driving prices isn’t sentiment, the answer is likely no. While in many respects the stock market looks like a bubble, the underlying foundation is different. This is a very expensive market, but it's likely not a bubble. That doesn’t mean it can’t go down, of course, potentially by a lot.
What If Rates Rise?
We still have an open question, for example, of what happens if rates start to rise. This is a real risk, but the Fed has said it will be some time before it lets rates go up. Any rate increases are likely to be slow and measured, which will give markets time to adjust. That said, higher rates would affect the markets, reversing the trends that have gotten us to this point.
The other open question is that sentiment is indeed very positive, and the effects when it changes are likely negative as well. Beyond the headlines, however, if you look at volatility and P/Es (as we do in the Market Risk Update every month), sentiment is not as positive as all that. Could it have an effect? Certainly. Would it sink the market? Not necessarily.
Not A Classic Bubble
Big picture, there are reasons to believe this market is not in a classic bubble. Does this mean we won’t see a market decline? Of course not. Even in the absence of a bubble, markets can drop significantly, as we have seen multiple times in the past decade. Bubble or not, we can certainly expect more volatility, because whatever happens with interest rates or sentiment, that is one thing that will not change about markets.
Brad McMillan is the chief investment officer at Commonwealth Financial Network.