Where’s the Party?

Jonathan Clements  |  May 12, 2018

WE HAVE CRAZY stock market valuations in the U.S.—and yet investors don’t seem especially crazed, at least compared to the two great buying manias of recent decades.

Six months before the housing market peaked in mid-2006, I remember attending a New Year’s Day party where real-estate investing was—no exaggeration—the sole topic of conversation. I recall colleagues walking into open houses and, after quickly looking around, bidding above the asking price. I remember emails belittling my intelligence for cautioning readers about the likely return from real estate.

And I’m hardly the only person with such stories. Homeownership is so widespread—even today, 63.7% of U.S. families own their house—that it’s hard to find anybody who doesn’t have a housing bubble tale to tell.

Stock ownership is less widespread—it’s now around 51.9%—and the late 1990s are starting to seem like ancient history, so the tech-stock bubble isn’t quite so firmly lodged in our collective memory. Still, it was a wild time.

Recently, I was leafing through a book I wrote in the midst of the 2000-02 market decline, entitled You’ve Lost It, Now What? It reminded me of all the nonsense we saw in the late 1990s: the desperate desire for 100 shares of the latest IPO, the book that predicted Dow 36,000, the mutual funds that notched 100% gains in a single year, all the talk of the New Economy and how “the internet changes everything,” the way tech companies were valued based on their “burn rate”—how long it would take these money-losing startups to burn through their corporate cash.

Today feels quite different. Yes, we’ve had the hoopla over bitcoin. Yes, in recent years, the obsession with the FANG stocks—Facebook, Amazon, Netflix and Google (now Alphabet)—is somewhat reminiscent of the one-decision “Nifty Fifty” growth-stock mania of the late 1960s and early 1970s. Yes, we’ve had some fringe weirdness, like leveraged exchange-traded index funds and funds that short volatility.

But while the anecdotal evidence isn’t especially alarming, the numbers are: The S&P 500 stocks are trading at more than 24 times earnings and yield just 1.9%—both rich by historical standards. The Shiller price-earnings ratio—which measures share prices as a multiple of average inflation-adjusted earnings for the past 10 years—has lately been at levels rivaling those of 1929 and surpassed only in the late 1990s and early 2000s.

This is puzzling: If valuations are arguably crazy, why aren’t people acting crazy? Maybe the craziness will be clear only in retrospect. Perhaps we’ll look back and be astonished that investors didn’t question the trillions that companies spent buying back their own stock. Maybe we’ll marvel at the way rising profit margins and falling corporate tax rates papered over sluggish underlying growth in company earnings. Perhaps we’ll discover that low interest rates and rising stock prices have masked all kinds of financial foolishness.

Alternatively, perhaps we’re now dealing with financial markets that are so dominated by professionals that the archetypal “dumb” small investor—whom both Wall Street and the media love to heap scorn on—simply isn’t much in evidence anymore. In recent years, the net flow of money into stock funds has been lackluster, with index funds gaining new investor dollars and actively managed funds seeing net redemptions. Indeed, today’s most important active investors aren’t individuals, but institutions—and institutions try hard not to appear giddy in public.

Another possibility: Perhaps investors are buying stocks today not out of enthusiasm, but out of disdain for everything else. I haven’t had any emails saying stocks are a great buy. But I’ve heard from plenty of readers who think bonds are a terrible investment. Maybe the craziness isn’t that folks are buying stocks, but rather that they’re shunning bonds.

But guess what? Even as stock valuations seem scary, bonds are looking less terrible. The 10-year Treasury note is now at 2.97%, up from 2.41% at year-end 2017—and more than the double the 1.37% yield we saw in July 2016. I’m not saying 2.97% is any great bargain. But with annual inflation at 2.5% and a marginal federal tax bracket of, say, 22%, you can now buy 10-year Treasurys and almost hold your own against the twin threats of inflation and taxes.

To be sure, interest rates could climb further from here. Let’s say you own Vanguard Group’s total bond market index fund, which currently yields 3.1%. Even if interest rates rose a full percentage point, the fund would dip just 6%. That would sting—but it’s nothing compared to the potential loss you could suffer with stocks.

Nervous about share prices? Got money in stocks that you’ll need to spend in the next five years? For much of the past nine years, bonds have seemed like a wretched alternative to stocks. But today, keeping part of your portfolio in bonds looks like reasonably priced insurance against the risk of a vicious stock market decline—and yes, at today’s valuations, that risk is real.

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