Is the Stock Market Getting Frothy?

Given that the Dow Jones Industrial Average (DJINDICES: ^DJI  ) recently crossed the 15,000-point threshold for the first time in history, it should come as no surprise that there's an ongoing debate about whether stocks are headed for another bubble.

The title of a recent CBS MoneyWatch article sums up the sentiment perfectly: "Stock Market Bubble: Red flag warning." According to the author, there's reason to believe that stocks are becoming "frothy" because margin debt -- that is, the debt that investors use to purchase stocks in the brokerage accounts -- is headed for another peak akin to the dot-com and housing bubbles. Here's a chart to demonstrate the point:

But there's another side to this story. Enter Josh Brown, author of The Reformed Broker -- a blog I encourage readers to check out. In a post published at the end of last week comparing the stock market in 1999 to today, Josh makes a convincing argument that all of this concern is much ado about nothing.

Here's a very rudimentary but essential thing to be aware of -- in 1999 the S&P 500 (SNPINDEX: ^GSPC  ) finished at 1469, earned 53 bucks per share, and paid out $16 in dividends. These are nominal figures, not adjusted for inflation.

The 2013 S&P 500 is earning double that amount -- over $100 per share. The index will also be paying out double the dividend this year, more than $30 per share, and returning even more cash with record-setting share repurchases.

This sounds pretty good; what's the catch?

What kind of premium, pray tell, are we paying for double the earnings and twice the dividend yield versus 1999's market? I'm so glad you asked -- turns out we're not paying any premium at all. We're paying a discount. 50% off. The current S&P 500 trades for a P/E of 14 versus 33 for 1999. So double the fundamentals for half the price.

Sound frothy to you?

Josh then goes on to discuss the Case-Shiller cyclically adjusted P/E ratio, or CAPE. For those of you who aren't familiar with this metric, it's a 10-year rolling average of the S&P 500's P/E ratio. Its advantages are twofold. In the first case, it's the most widely available historical valuation metric you can find for the broader market -- do a search for the S&P 500's historical P/E ratio, and it's basically the only game in town. And in the second case, as its name suggests, by controlling for cyclical variations in valuation multiples, it makes for a nice, smooth line to include in charts.

But, as Josh points out, there's a problem with relying on this metric to make contemporaneous investment decisions. That is, by including the last 10 years of valuations, the CAPE overstates the S&P 500's current multiple by nearly 38%. You can see this in the following chart, which compares the index's actual P/E ratio to the CAPE.

S&P 500 P/E Ratio Chart

S&P 500 P/E Ratio data by YCharts

Suffice it to say, the current gap is a function of the financial crisis, shortly after which corporate earnings were eviscerated and thus valuation multiples shot through the roof. This trend was particularly robust in the financial space, where large banks such as Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) were forced to record massive losses because of overexposure to subprime mortgages.

So where does this leave us?

I believe that the truth lies somewhere in the middle. Let's take a look at one last chart (the explanation follows).

This is an index that compares the gross domestic product to corporate profits to the Dow -- all of which are adjusted for inflation. Over the long run, there's a strong correlation here -- if you work backwards from the Dow, this shouldn't be surprising. The overarching trend and magnitude of increase, in other words, is pretty closely aligned among the three variables.

Yet at any one time in particular, there are discrepancies. The most notable of these were the 1960s -- the so-called "Go-Go Years" -- and the time period surrounding both the dot-com and housing bubbles. In each case, the performance of stocks outpaced GDP. And in each case, these intervals were concluded in dramatic fashion by stock market crashes.

To get back to the present, if you look to the far right side of the chart you'll see that the Dow has once again eclipsed the GDP trend line -- it should be noted, moreover, that the extent of the eclipse is understated, since the data stops at the end of last year. If history is any guide, in turn, this is indeed indicative of an overheated market.

On the other hand, to Josh's point, corporate profitability appears to be a primary impetus for the climb -- though, as you can see, this was similarly the case in the mid-'60s, late '90s, and early '00s. In addition, we obviously have a long way to go before the present resembles anything like those previous bubbles.

My point here is this: Stocks are high. On a comparative basis, are they as high as they were during these earlier periods of excess? No. And could they go higher? Yes. Absolutely. In fact, I'm inclined to think they will in light of the Federal Reserve's ongoing liquidity measures. But these factors aside, it's important that investors have a decent idea of where we're at.

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  • Report this Comment On May 18, 2013, at 4:57 PM, VVTJR wrote:

    Very GOOD analysis

    There's a few more reasons that the stock market may go even higher.

    For one fund managers and private investors may find the commodities increasingly less attractive in performance terms and reallocate their assets into stocks.

    The bond market (high bond prices) is most likely set for a correction if interest rates climb. For now most short term government papers yield near zero or some have even negative yields in real terms.

    Trading currencies is also becoming more confusing and risky due to the monetary policies being constantly modified around the globe.

    Basically owning stocks pays for now, most likely for a crash to occur we would need exactly the exaggeration criteria you mentioned and also a flat bond yield curve with increasingly volatility on the stock market.

    For now Abe-nomics (QE) seems to be working and rising equity prices may fund spending and capital gains taxes, further improving GDP growth and decreasing government deficits.

  • Report this Comment On May 18, 2013, at 6:31 PM, PEGformula wrote:

    What pundits fail to mention is that the historical average PE value for the S&P500 is about 13 including all years less the recent bubble valuation years which accordingly should be treated as outliers and today is far from average being we are in a masked depression. Relating PE ratios with bad economic times you would see that the S&P500 tends to 6-8 and surely below 10, and because today is far worse in all of our history with our debt, globalization effects that hurt first world countries, and increased efficiency that leaders fail to recognize in lowering the cost of living to enable a lower legal workweek to get more people employed, a fair PE value would be about 5. So why is it 3 times this? It is a bubble and it was clearly a bubble in late 2009. March 2009 prices made sense but the Fed stepped in to do their unlawful manipulation that had nothing to do with their mandate. Please don't mislead the public with wording suggesting that this might be headed for a bubble - the bubble has been with us for a long time already. When the public really wants to address the underlying issues, go read and then lead your failed leaders.

  • Report this Comment On May 18, 2013, at 6:35 PM, PEGformula wrote:

    I don't get what VVTJR says as it appears this mirrors what the pundits want you think. Equity prices have nothing to do with the health of the economy. Abenomics is not a cure for Japan just like Bernanke is not helping the United States with the anti-stimulus QE. There is nothing as far as any program within the policy to effect any positive change - taking more from the responsible poor and middle class and handing to the wealthy does not make any economy better but worse. A compression of the wealth divide would be a stimulus but what is being done is the opposite.

  • Report this Comment On May 18, 2013, at 6:55 PM, michaelbinCA wrote:

    Get on your Marx.

    Get set.


  • Report this Comment On May 18, 2013, at 9:01 PM, ryanchandler25 wrote:

    I love how they call a ten year rolling average of the p/E the Case-Shiller, as if they were the ones who thought of the idea. Ben Graham advised investors to average out the multiple over 60 or 70 years ago.

  • Report this Comment On May 21, 2013, at 7:11 PM, thecinimod wrote:

    You're clearly not familiar with Stigler's Law, then:'s_law_of_eponymy

  • Report this Comment On May 21, 2013, at 7:16 PM, akutach wrote:

    I think Josh Brown is double counting by saying the fundamentals (earnings) are double and then for half the price (based on per earnings which he just said were double). Point taken.

    The 38% overstatement of CAPE is a bit of an exaggeration, but I'm not sure about the math. His criticism is that it includes the massive bank write-downs that drove earnings into serious outlier territory. That's true, but how much of the preceding 6 years' profits were inflated based on the same false premise of bond value generation or income from sales of inflated-value homes and land?

  • Report this Comment On May 22, 2013, at 12:27 PM, akutach wrote:


    This is the second time in two days that the leverage chart was posted in a MF article. I don't think that margin dollars inflation adjusted necessarily indicates a stretched market. It seems to me that the risk lies in what assets back that leverage, their correlation risk. That is, a squeeze could occur with a massive margin call if those using the leverage are highly leveraged or holding volatile assets. That would happen broadly across a market of investors if they are all using leverage to buy the same types of assets (or highly correlated assets).

    Does this data come with any such analysis of what the leverage is being used to buy, or what the borrowers' collective credit risk is? My inner cynic says the bulk of it is very short term leverage used by trading desks at financial institutes. I'm curious to know.


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