Behind the Stock Market Bubble Talk: A Lot of Hot Air

There’s a bubble in bubbles on Wall Street -- or at least a bubble in blathering about bubbles. For evidence, consider the big, fat bubble that floated on the cover of the November 18th issue of Barron’s. You’ll also find the bubble meme in recent headlines: “5 signs the stock market is in a bubble” (CBS News); “‘Definitely a bubble brewing’ in stocks: Pro” (CNBC.com) and “As market bubbles form, investors may want to take cover” (Reuters).

3 Reasons the Stock Market Is Not Overvalued (and One Reason It Might Be)

Here’s the real bubble trouble: When you’re really in one, you rarely hear about it. To those inside, bubbles are almost always invisible.

Economist Ed Yardeni calls all the talk about bubbles “Bubble Balderdash” in a recent briefing to clients. Record-high stock prices aren’t in themselves cause for concern, he says, especially considering projections for record-high earnings next year. Yardeni’s target for Standard & Poor’s 500-stock index is 2014 by the end of 2014. That’s 12% above the November 21 close of 1796.

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What worries more is the possibility of a “melt up” -- stock prices climbing so high, so quickly that the S&P hits his target by, say, early next year. That could set the stage for a nasty correction.

But for now, bubble speculation is premature. Market guru Jim Stack, who has published the InvesTech Research newsletter since 1982, has some experience spotting bubbles. He was a lonely bear on the stock market in the late 1990s, refusing to embrace a “new paradigm” rationale for sky-high prices for tech stocks and big-capitalization growth stocks. That bubble burst in early 2000.

Stack readily admits that stocks aren’t cheap anymore, but he doesn’t yet see the “can’t lose” and “gotta be on board” speculative mentality that marks a bubble. “Instead, we would simply say that stocks are richly priced, and any significant move higher from these levels will have to be accompanied by rising revenues and earnings,” Stack recently told clients.

The extremes that typically portend a bubble, or even a market top, have yet to materialize, says Liz Ann Sonders, the chief investment strategist at Schwab & Co. “Everyone’s poised for the next big crisis,” she says. “First, there was Europe, then dysfunction in Washington and now, oddly, we’re in a bubble.”

Just as bubbles are invisible, no one rings a bell at market tops, says Sonders. But there are signs to look for that in the past have signaled the end of a bull market. Among them:

Interest rates, after adjusting for inflation, are rising. This is the only sign that’s in place at the moment, says Sonders, and it might not be as telling as it has been in the past. “The reason real rates are climbing now is that inflation has been falling -- you could even argue that inflation-adjusted rates are going up for a good reason, not a bad reason.”

A significant pickup in initial public offerings and, in conjunction, a surge in merger and acquisition activity. “We’ve seen a pickup in both of those things,” says Sonders, “but nothing like what we’ve seen at previous market tops.” More than 140 IPOs have debuted in the U.S. so far this year, a 52% increase from all of last year, according to according to data compiled by University of Florida finance professor Jay Ritter. Their average first-day pop: 21%. In 1999, 477 stocks debuted, and the average one-day return was 71%.

Frothy fund flows. Yes, the money flowing into U.S. stock funds has accelerated this year, with stock mutual funds receiving nearly $30 billion more than has come out of them. But that’s hardly enough to make a dent in the roughly $600 billion in net outflows since 2008. In fact, “there is no investing cohort that has gone hog wild into the market,” says Sonders. Hedge funds on average hold less than 50% of their assets in stocks, Sonders says. Moreover, stock holdings by foundations and endowments have dropped precipitously over the past decade, in favor of alternative asset classes (which are lagging traditional stock investments).

Overvalued stock prices. Stocks in the S&P 500 are trading at about 15 times estimated 2014 corporate earnings. The average long-term price-earnings ratio on estimated year-ahead earnings is 16.5, and the average at market peaks dating back to 1956 is just over 18. “People are obsessed that there’s a bubble in the market,” says Sonders. “But I’m not sure why that view has taken hold.”

Anne Kates Smith brings Wall Street to Main Street, with decades of experience covering investments and personal finance for real people trying to navigate fast-changing markets, preserve financial security or plan for the future. She oversees the magazine's investing coverage, authors Kiplinger’s biannual stock-market outlooks and writes the "Your Mind and Your Money" column, a take on behavioral finance and how investors can get out of their own way. Smith began her journalism career as a writer and columnist for USA Today. Prior to joining Kiplinger, she was a senior editor at U.S. News & World Report and a contributing columnist for TheStreet. Smith is a graduate of St. John's College in Annapolis, Md., the third-oldest college in America.