The 1 Bubble Warning Worth Listening To (It Isn't One!)

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Following an eight-week winning streak, stocks kicked off December with a down day as the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) fell 0.3% and 0.5%, respectively.

This month, my colleague Morgan Housel explained "How the Media Blows Bubbles." It's an important question, as stocks have continued to move higher with impressive regularity, the B-word has been popping up with increasing frequency in the financial media.

While most would-be seers in the media and finance aren't worth spending a minute of your time on, Robert Shiller of Yale is worth listening to. Shiller is one of the recipients of this year's Nobel Prize in Economics for his work on the predictability of long-term stock returns; better yet, he's tested his work "by fire," making some prescient calls, including the dot-com bubble and the real estate bubble.

Over the weekend, the German weekly Der Spiegel published excerpts of an interview with Professor Shiller, including the following quote [my emphasis]:

I am not yet sounding the alarm. But in many countries stock exchanges are at a high level and prices have risen sharply in some property markets. That could end badly. I am most worried about the boom in the U.S. stock market. Also because our economy is still weak and vulnerable.

All well and good, but how does Shiller himself invest in that environment? He's invested in stocks -- "those he still believes are undervalued." Within that group, he counts stocks from the energy and health-care sectors. As far as the finance and technology sectors are concerned, he's out of those entirely.

Here's a way to think about the market's performance and its valuation: By my reckoning, 50 stocks in the S&P 500 -- one in 10 -- account for roughly half of the year-to-date rise in the index (remember, the S&P 500 is market capitalization-weighted). The median forward price-to-earnings multiple for those 50 stocks is 16.8. The average forward P/E, weighted by market value, is 18.5; once you remove Amazon.com (NASDAQ: AMZN  ) (P/E 176!) from the group, that average falls to 15.7.

(Even for Amazon, I think there is an argument to be made that, given the size of the opportunities the company is pursuing and management's long-term focus, the shares aren't overvalued. Still, I wouldn't expect huge returns from current levels.)

Those are hardly the sort of numbers that would suggest a market in the throes of generalized euphoria. Facebook (NASDAQ: FB  ) offering $3 billion in cash to acquire photo-messaging application Snapchat? That is irrational exuberance, yes -- the sort that can quickly torch shareholder value. (Facebook investors ought to be very grateful that Snapchat's management was even more deluded and turned the offer down!) Twitter gaining 73% on its first day of trading? Same thing. However, those are examples of a "local phenomenon," that concerns social-networking equities, not a broad speculative bubble.

Let me state things categorically: We're not in a stock market bubble. However, it's quite possible that stocks are 10% to 20% overvalued. That needn't exclude long-term investors from investing in shares, but stock pickers ought to make the most of their privilege to focus on issues that still offer value and avoid those that are manifestly overpriced.

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