High Valuations Leading to Stock Market Bubble
We could be seeing a giant bubble form on the stock market. It could go on for a bit, but when it pops, don’t be shocked if there are tears.
But before I go into any details, let me explain what really constitutes a market bubble. A bubble forms when the stock market trades at extremely high valuations backed by investor euphoria and irrationality—and while economic conditions are dire or not expected to improve much.
At the moment, valuations are extremely high.
Look up any valuation measure of the stock market and you’ll see that stocks are trading at very expensive prices. The price-to-earnings (P/E) ratio says stocks are expensive. The price-to-sales (P/S) and price-to-book (P/B) ratios say the stock market is trading at its highest price in several decades. Even valuation measures closely followed by legendary investors like Warren Buffett (i.e., the market cap to GDP ratio) says the stock market is significantly overvalued.
Irrationality Prevails on the Stock Market
Investor euphoria and irrationality right now is extreme, to say the least.
In 2020, we saw investors rush to buy shares of bankrupt companies in hopes of making high returns. Nowadays, you see investors bidding up the shares of companies that don’t really have much going on. The only reason investors have been buying them is that someone tweeted about them, or they heard about the stocks through social media.
Look at GameStop Corp. (NYSE:GME), for example. It’s been an interesting stock to watch lately. The company reported mediocre financials and had a management change, plus a short research firm had a bearish call on it.
Result? See the chart below:
Chart courtesy of StockCharts.com
In a matter of days, GME stock went up from about $10.00 all the way to about $150.00. This represents an increase of about 1,400%. Here’s the kicker: even after this much growth, there has been talk about how GameStop stock could go a lot higher.
Mind you, GME stock is the poster child for investor euphoria and irrationality, but it’s not the only one. Stocks left, right, and center have been showing returns that are uncanny, to say the least.
Economic Performance Is Dismal at Best
As for the economy, it’s really not growing, and there are a lot of risks ahead.
Anyone who thinks 2021 will be a year when we see robust economic growth is not really looking at the big picture. We’re in the midst of a pandemic, and restrictions will be around for a while. All of this will have impact on the economy.
But don’t just get fixated on the U.S. economy. Globally, there’s also a struggle. Major regions are facing a lot of economic pressure, and robust growth is not in sight.
What Happens When the Stock Market Bubble Pops?
Dear reader, don’t just listen to what I have to say. Go look at what happened to the stock market in previous bubbles and I bet you’ll find a significant amount of resemblance to the situation unfolding now.
Here’s what you should know: bubbles can go on for a long time, but eventually they become unsustainable and they pop. When they pop, you tend to see a major stock market crash—a painful one.
I’m sitting back and watching all this very closely. It’s certainly very difficult to call for a bubble when everyone seems to be making an immense amount of money, and almost everyone thinks stocks could go a lot higher. I suggest that investors don’t get too complacent, and that they, now more than ever, focus on capital preservation. The stock market could run up a bit because investors are getting too greedy, but the higher the market goes, the bigger the downside.