“Are we in a stock market bubble?”
I’ve heard a lot of people asking that question recently.
I’ll provide my answer to that question in today’s post, but…it’s the wrong question to ask.
In addition to answering the “Bubble Question”, I’ll provide 5 more important questions you should be asking instead.
If you're asking about a stock market bubble, you're asking the wrong question. Here are 5 questions you should be asking instead. Click To Tweet
Are We In A Stock Market Bubble?
So, the big question. Are we in a stock market bubble?
Executive Summary: I provide my answer to that question below, but more importantly I also provide the 5 questions that you should be asking instead. A Bear Market is looming. Are you prepared?
Trying to determine whether we are in a stock market bubble is, essentially, an effort to time the market. While we can look at valuation metrics, trying to call “the top” is an exercise in futility. I could write an entire post on current views about the stock market, but the reality is that you can easily find articles to support both bearish and bullish arguments. (Want proof? Here’s a bullish article, and here’s a bearish one.)
What we do know is that a bear market will arrive at some point in the future. The bear never dies, he just hides in the woods for years at a time. You can be sure at some point in the future he’ll come back out of hiding. It’s his nature. The more important questions are the ones you should be asking to address this reality, and we’ll get to those in a minute.
First, a few quick words about how I think about market valuation. I honestly don’t pay too much attention to it. Rather, I focus on the questions raised in the bottom section of this post. I trust my rebalancing and asset allocation process to tell me when to buy or sell, and I don’t try to time the market.
That said, if there’s one market valuation I pay a bit of attention to, it’s the CAPE Ratio (defined here). More relevant, I think of the CAPE Ratio in conjunction with what it means for potential future returns in the stock market. Following is a relevant Advisor Perspectives chart (with current CAPE added by me) from their article: “The Remarkable Accuracy of CAPE as a Predictor of Returns”:
In fairness, the chart only addresses a 25-year time horizon, and one could argue that today’s market and interest rate environment could change the correlation versus the 1995-2020 timeframe above.
As I write this post on February 2, 2021, the CAPE Ratio is 34.9. (source: multpl.com): By simply looking at the chart above, you can see that at the current CAPE Ratio the prospect for 10-year returns in the S&P500 is <5%, well below its historical average of ~10%. I don’t know the answer to “are we in a stock market bubble” (though I will answer it, as promised, below), but I do know the historical correlation between the current market valuation and future returns. Draw your own conclusions.
If I were to try to predict the S&P500 return over the next 10 years, I’d guess we’ll be looking at something below 5%, based on the historical correlation. Feel free to argue, no one has the right answer. And again, if you’re focused on market valuation, you’re not asking the right question.
Finally, I’m a firm believer in maintaining a diversified portfolio, given the reality that it’s impossible to predict which sector will perform well over the coming years. One of my favorite charts is the Callahan Periodic Table of Investment Returns, which demonstrates my point:
My Answer To “Are We In A Stock Market Bubble”
Since I started my post with that question, it’s only fair that I provide my response. For the record, here’s how I’ll answer that question:
Here's my answer to the question: Are We In A Stock Market Bubble? Click To Tweet“The market is currently at the high end of historical valuations, and based on past correlations the market returns over the next 10 years will likely be below the long-term average of 10% (with increased volatility along the way, I suspect). That said, given the unusual market dynamics (e.g., low-interest rates), it’s possible the market will be stronger for longer than one would expect. Don’t try to time the market. Rather, realize that the prospects of a bear market increase with every passing day, and answer the 5 questions you should really be asking, which are outlined below.”
– Fritz Gilbert – The Retirement Manifesto
(Disclaimer: I’m just an old retired guy who blogs, not a financial expert. Don’t take my forecast to mean anything, and don’t make any investment decisions based on my comments. Rather, let’s just agree to check back in sometime in 2031 to see how wrong I was with my forecast. Because we all know, I’ll be wrong. Right?)
Rather than focus on things that don’t matter, let’s turn our attention to the things that do.
The 5 Questions You SHOULD Be Asking
Rather than asking “Are we in a stock market bubble”, I’d encourage any responsible investor to ask themselves the following 5 questions, which are applicable regardless of market valuations. Answer them correctly, and you’ll worry less about whether we’re in a bubble.
1. How Much Risk Can I Tolerate?
When thinking about risk, you need to think about both your “Risk Tolerance” and your “Risk Capacity”, both of which are summarized below (source: Investopedia):
Risk Tolerance: Personal risk tolerance is the amount of risk that an investor is comfortable taking or the degree of uncertainty that an investor is able to handle. Risk tolerance often varies with age, income, and financial goals.
Risk Capacity: Thanks to Jay’s comment below, I’m refining my definition of Risk Capacity based on this article which Jay shared: “How much risk a client can afford to take without risking his/her objectives”. One should also analyze “Risk Required”, which is how much risk is necessary in order to meet a client’s objectives.
From the Investopedia article: “The problem many investors face is that their risk tolerance and risk capacity are not the same. When the amount of necessary risk exceeds the level the investor is comfortable taking, a shortfall most often will occur in terms of reaching future goals. On the other hand, when risk tolerance is higher than necessary, the undue risk may be taken by the individual.”
How much risk you’re able to tolerate, and how much risk you’re required to take to earn your required returns, are essential questions you must answer to ensure you’re portfolio is appropriately allocated among various asset classes. If you were having trouble sleeping during the March 2020 market correction, your asset allocation was likely misaligned with your risk tolerance. Now that the market has recovered, it’s an excellent time to reposition your portfolio for better alignment. If your rebalance strategy (see #4 below) calls for it, sell some of those stocks now that the market has recovered, and rest easier during the next correction. Don’t wait until a correction to sell.
In my case, I’m a conservative investor, with limited risk tolerance. Fortunately, we’ve designed a conservative withdrawal strategy to fund our retirement, so our risk capacity is aligned with our tolerance. Our asset allocation (see Q2 below) reflects that reality.
2. Does my Asset Allocation Align With my Risk Profile?
Stocks are high risk, and their historically higher returns are accompanied by high volatility. Cash is low risk, but in return for low volatility, you’ll earn meager returns. How do you balance the need for returns with the desire to avoid volatility? From Investopedia:
“Asset allocation is an investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon. The three main asset classes – equities, fixed-income, and cash and equivalents – have different levels of risk and return, so each will behave differently over time.”
Determining your appropriate Asset Allocation is the second key question you must answer as you prepare for retirement. As you near retirement, it’s typically recommended that you “de-risk” your portfolio to avoid sequence of return risk. In our case, we target 50 – 60% stocks, with the balance in bonds/stocks/alternatives. We target 3 years worth of spending in cash. As mentioned above, I’m also a strong believer in maintaining a diversified portfolio and include a wide variety of equity exposure (International, Small Cap, etc.), as well as a 10% “Alternatives” segment to gain some exposure to commodities, gold, real estate, etc.
An example of how your Asset Allocation could change as you approach retirement is summarized in this chart from my post A Simple Guide To Targeted Asset Allocation:
For more on Asset Allocation, read the following:
- Why Is Asset Allocation Important?
- A Simple Guide To Targeted Asset Allocation
- I’m Scared of a Crash…Where Should I Put My Money?
3. How Do I Fund My Retirement From My Portfolio?
One of the most significant changes that comes with retirement is moving from the Accumulation Phase to the Withdrawal Phase. Figuring out how to make this transition is a more important question than “Are we in a stock market bubble”, and should consume significant focus in your final years of work.
I’ve written tens of thousands of words on this topic, and it’s impossible to summarize in a few paragraphs here. Therefore, I’ve listed three of my most read articles on the topic below. Dive as deep as you’d like, it’s a critical question you must answer:
- How To Build A Retirement Paycheck From Your Investments (The Bucket Strategy)
- Our Retirement Investment Drawdown Strategy
- 20 Steps To Take In The Year Before Retirement
4. When & How Do I Rebalance My Portfolio
If done correctly, rebalancing your portfolio will ease your concerns about “Are we in a stock market bubble”.
Why?
Rebalancing is the act of maintaining your targeted asset allocation over time via the selling of whichever class has outperformed and buying those classes that have under-performed. If the stock market IS in a bubble, your rebalancing strategy should trigger you to be selling some stocks since they’ve risen in price. All else being equal, if stock prices have gone up the % of your asset allocation dedicated to stocks will have risen. To maintain your targeted asset allocation, your rebalancing strategy would trigger a sale of stocks and reinvestment in the other asset classes which haven’t risen at the same pace. Similarly, if when we enter a bear market, your rebalancing process would trigger a sale of your other asset classes and a purchase of stocks.
Buy low, sell high. Automatically. The beauty of a well-executed rebalancing strategy.
Determining your rebalancing strategy is a critical question to answer, and must be done in conjunction with a sound withdrawal strategy to ensure you don’t outlive your money. At a minimum, you should rebalance annually, in conjunction with your year-end Annual Financial Update. When markets become more volatile, you should consider increasing the frequency of your rebalancing. During the March 2020 market correction, I was rebalancing much more frequently, a strategy I wrote about here.
For more information on how to establish a rebalancing strategy, read the following articles:
- A Simple Guide To Targeted Asset Allocation
- How To Manage The Bucket Strategy
- A Step-By-Step Guide For Your Annual Financial Update
5. What’s my Contingency Plan for the Next Market Crash?
Rather than asking “are we in a stock market bubble”, you should be focusing on developing a contingency plan BEFORE the next market crash occurs.
Developing your contingency plan before you need it will help ensure you don’t panic and sell after stocks have declined, which is one of the worst things you can do with your retirement portfolio. By answering each of the 4 questions above, you should have your plans in place. Focus on aligning your asset allocation with your risk tolerance/capacity, and implement a consistent rebalancing strategy. Understand your safe withdrawal rate, and implement a cash cushion (the primary objective of The Bucket Strategy) to avoid selling in a bear. Taken together, those are the keys to avoiding longstanding damage when the next crash occurs, regardless of whether we are in a stock market bubble or not.
- 6 Steps To Avoid The Looming Bear Market
- A Strategy For Buying Into A Bear Market
- Resilience In The Face Of Market Volatility
Conclusion
Are we in a stock market bubble?
By many measures, the stock market could be considered over-valued at current levels. But it’s impossible to call the top, and I have no idea if we’re in a bubble. To be honest, I don’t really care.
By focusing on the 5 Questions You Should Be Asking, and implementing a sound strategy for maintaining your investment portfolio regardless of market conditions, you’ll worry less about stock market volatility and enjoy life a bit more.
Don’t let worries about money ruin your life. Build your strategy to manage your investments (or hire an expert to manage it for you), then get on with living life. In our case, I update our Net Worth and rebalance our asset allocation every January (unless volatility becomes extreme), and focus very little attention on it for the remainder of the year.
It works for me.
Maybe it’ll work for you.
Your Turn: Do you worry about whether we’re in a stock market bubble? Do you agree the other 5 questions are the more important ones to ask? How do you defend against a market downturn? Let’s chat in the comments…
Looking at the CAPe/market returns chart, it would have predicted about a 5% gain for 2020 – and been dead wrong. The S&P500 gained 16.3%. Further evidence of the futility of trying to predict markets.
There are ALWAYS two dozen perfectly sound reasons for the market to go up, and two dozen perfectly sound reasons for the market to go down – always.
JD, I believe the correlation predicts the future 10-year return, not the 1-year return cited in your comment. Time will tell, but I agree that there’s a plethora of evidence demonstrating the futility of trying to predict the markets, which I why I focus on those other 5 questions.
When it comes to Wall Street (Free Market) 99% of the population in anywhere on the planet earth are playing the musical chair game (with just ONE CHAIR calculated with Math+Psychology).
Here is the Great States of America, we have fair enough regulations that ensure the DUMBS 99% are protected with basic necessities when the music ceases.
Most of us do not have the desire (passion) NOR the skill to manage the risks into the acceptable range. It is GREED and CHILDISH and COMPULSIVE behavior that will eventually leave you standing without a chair.
(Fritz…if you ever decided to start a hedge fund -THE FRITZ BUFFETT- on your own, I will put my money in it!)
Don’t hold your breath for that hedge fund, TE. That’s the last thing I want to do in my retirement! (I do, however, appreciate your confidence in my investing prowess. Wink).
Love the disclaimer. I tell everyone that I’m a computer scientist by education and profession, didn’t take a single business or finance class in college, so I’m not qualified to answer any financial questions other than 31 years of watching hot shots on Wall Street try to chase the market while slow, steady investing seems to always win out.
When the Gamestop stuff was happening, my portfolio took a hit. A week and a half later, everything seems to have returned back to their previous levels.
Between stocks (mutual funds), bonds, and cash, I do the extremes, stocks and cash, and don’t own a single bond. I figure if I live another 30-50 years, the stocks should continue to grow and the cash is just an oversized emergency fund to ride out and storms.
Personally, I don’t have a big issue with someone holding cash instead of bonds. It is “Personal” Finance, after all! And yes, you’ve gotta love those disclaimers. I don’t need someone pointing out this post in a lawsuit in a few years saying they sold all of their stock because of what I wrote. I’m just an old guy who knows nothing, after all!
Asset allocation or balance very important. Bonds and cash are a factor in any portfolio. No one can see the future so disturbing assets is not only an offensive move but also defensive.
Thanks Fritz. On the CAPE Ratio vs. S&P 500 Return chart, the Advisor Perspective article states that the S&P returns are nominal (before inflation) but fails to state if the returns include reinvested dividends or just price appreciation. For this audience and our current environment, the (nominal vs. real) and (dividends vs. no dividends) are key details to consider. We may be in a low inflation environment now which helps keep the data point higher on the chart. If inflation takes off and lowers the real return, the next data point may be lower on the chart. For dividends, this audience may be counting on dividends in their retirement income stream which could affect the data point on the S&P 500 chart. Please provide any clarification if you can.
Fair point about nominal vs. real returns, Kile. While those may be key details to some, it’s an area that I don’t focus my time. I do agree on your point about dividends given the number of folks who count on them to fund their retirements. I read through that link again, closely, and agree they didn’t clarify whether it included dividend reinvestment or not. Nice catch, afraid I’m unable to provide clarity. Then again, my main focus is on those 5 questions, which are elements in investment management that are within our control…
Lots of excellent advice in this post. Risk tolerance can be a challenge to get your mind around and as mentioned in this post, it changes as we age and with life circumstances.
I’ve been a fan of Paul Merriman for over a decade. He has decades of experience as a financial advisor, but in retirement he focuses on financial education with his foundation. Frequent posts on his website and a weekly podcast are great resources for those interested in portfolio allocation based on historical averages and risk. And we all know that no one knows the future, so all we really have to work with is the past.
Paul has a set of tables that I’ve found particularly helpful in trying to get a handle on my own risk tolerance and return needs / expectations. In his ‘fine tuning tables’, at the bottom, you can see how a particular asset allocation performed in the past and also, perhaps more importantly, how poorly it has performed for periods of time. Using these tables can help an investor create a portfolio that matches their needed or expected return with a ‘real’ idea of what they might expect in losses over a particular period of time. For those interested, the link below is to Paul’s website and some of his many tables.
https://paulmerriman.com/fine-tuning-your-asset-allocations-2020-update/
Thanks for adding a valuable comment to the discussion, Mike. I’ve been a big fan on Paul Merriman for years, and was excited beyond words when he reached out to me for a phone chat a few months ago. Great link, thanks for adding value for the reader.
As always, I think you hit this topic perfectly, as a recent retiree, I find I have little worry about a possible bubble because I do all the above. The part that I focus on most is the spending and adhering to our budget. So as the old saying goes, that worrying is as effective as trying to solve an algebra equation by chewing bubblegum. So don’t worry about what you can’t control but focus where you can.
Great job on the post
Thanks for your kind words, Big M. Got any gum?
I enjoy your blog Fritz, but I have to ask… did you really answer the question?
While I appreciate the well thought-out steps, planning, and mitigation advice, it would have been nice to see a simple yes or no… and then proceed to address the qualifiers.
Yes. 🙂
Great post Fritz, it drives home what is important in planning for the inevitable bear market. Sound decisions made before the bear help eliminate poor decisions during the bear. I agree that worrying about a bubble is wasted time, as worrying has never solved any problem. Planning helps to solve problems in a proactive way. Instead of putting out fires, the whole portfolio is fire retardant!!!
Best to you,
Dan
Dan gets a gold star, perfect summary of the post. Thanks for summarizing the key point of the importance of being proactive when managing our retirement portfolios.
Very good article on the key to making money in the markets, DIVERSIFICATION! The world is changing so fast and the ITC (Information Technology Communication) revolution is changing many paradigms, including the global markets. I have to laugh at all of the TV Financial Pundits that have been calling for high inflation since 2007, and they have all been wrong. Many people lost a lot of money listening to them. So, as the article says, diversification! I will add my own caveat, I only invest in U.S. securities.
Wait a minute…”only U.S. Securities AND diversification” in the same comment? That’s why it’s called “Personal” Finance! In my case, I believe in the value of having an international slice in my pie, but I don’t judge others who feel differently. After all, you ARE the Cash Cow! With a name like that, who am I to judge! Moo….
Hello Fritz,
Excellent challenge. The companies in my stock and bond portfolio have an international foot print. Therefore, I do believe I am covered internationally.
Cash Cow
I’ve always discussed risk capacity as different than the risk required.
I went to Investopedia and looked around.
I found a different Investopedia article that reflects the way I use the terms.
Here
Taken from the article:
Here are also different components to consider:
Risk Tolerance: How much risk a client is willing to take in pursuit of better returns.
Risk Capacity: How much risk a client can afford to take without risking his/her objectives.
Risk Required: How much risk is necessary in order to meet a client’s objectives.
As examples:
A young person may have little assets accumulated toward their goal, but years give them an amazing risk capacity.
An older investor may have few years, but a large pension, or large flexibility of spending, or a large flexibility in how much they want to leave for a legacy.
Thank you! Thank you! I wasn’t happy with that Investopedia definition and tried to find something better, which you’ve just provided (you’re obviously more patient than I am, I gave up after a few minutes. Deadlines, you know?. If you don’t mind, I think I’ll revise the original post to refelct the definition you shared.
Did I mention, Thank you?!
Great article Fritz! Dumb question but can you elaborate on the CAPE plot a little more? I know its a 25 yr timeframe but what exactly do each of the blue dots represent? Is it a composite PE ratio for the S&P as a whole? It its for 25 yrs why are there so many points?
JD, from the link just above that chart:
“Here’s what it looks like when I model 10-year nominal, annualized, geometric returns starting every month from January 1995 through June 2010 (185 blue dots) as a function of their CAPE value during this period”
As for the CAPE ratio definition, see the link in the article for an entire post on the definition. And, no such thing as a dumb question! If you had it, it’s likely that many other readers did, as well.
Realizing that my powers of prediction for the stock market are weak to absent, I just ignore it. I have a plan, it’s a good plan, and I stick to it. So far that’s done me well.
Fritz- ANOTHER relevant post as usual. Exceptional analysis from you and your community.
I just have one counter point. This and other blogs have taught me to diversify and not worry about this data.
https://www.theretirementmanifesto.com/a-real-life-journey-to-financial-freedom/
I’m fortunate to have a pension; however, that bucket aside, we prefer this strategy.
1. Invest consistently, as much as you can, like the advice of J.L. Collins’ Simple Path to Wealth into 401k-type plans and IRAs.
2. Pay off all debts. Yes, even the home(s).
3. Live below your means but still have fun!
4. Look at real estate investing as another hedge against the market after completion of #1 – #3.
That simple strategy has carried us through the dot.com bubble, the housing crisis, COVID and other hiccups that came along over the course of 20 years of investing.
Joe, loving your new nic on your comment name. Smiles. Valid points, all, though I would encourage you to consider establishing some sort of rebalancing routine. Wade Pfau has written some great stuff on the importance of rebalancing, especially once you enter the Withdrawal Phase. If nothing else, have a look at your asset allocation every year-end. And, thanks for referencing J.L. Collins, definitely a rock star in the community.
I’ve always liked the wisdom of that great oracle, Al Czervik, played by Rodney Dangerfield in Caddyshack.
He tells his broker, “Buy, Buy, Buy! Oh, everyone’s buying? Then Sell, Sell, Sell!”
What I learned from Al is, don’t follow the herd! They are generally wrong and late. If everyone wants to buy, look around, it’s probably the top. Definitely if everyone is heading for the exit, it’s the bottom.
I think bubble and rebalancing (question #4) are related so I do think the question of whether we are in a bubble is relevant. If you do an automatic and constant stock/bond allocation, I understand whether we’re in a bubble is an irrelevant question. But if you calibrate your cash/bond allocations so that say, if the CAPE is higher that a certain level like 30, you slightly increase your cash/bond holding and vice versa if CAPE is lower than say 15. I loosely rebalance in this fashion and do track whether I think we’re in a bubble to tweak my cash/bond reserves.
Fair point, assuming the CAPE is one of your metrics for rebalancing timing. I tend to look exclusively at my asset allocation, though I do watch the overall market level as an indicator of when I should check in on any asset allocation changes.
I just wanted to thank you for the tremendous service you provide to the average person like myself. Your articles are informative and I love how you don’t pretend to know everything. I have learned so much from your articles. I am 5 months from retirement at age 62. I love your countdown articles and the ones talking about the first few months, and years afterwards. I loved the article about “Because I Can” as well. I am retiring because I can. I will be rereading lots of the articles in the coming weeks. Thanks again.
Congratulations on your fast approaching Starting Line, glad to hear my work is helping you on your final sprint!
Awesome post Fritz and I’m going to keep this open for a bit and work through all your links. I have now been Lean/Barista FIRE for almost 4 years and really want to explore your drawdown strategies as I am refining mine and looking more at my bond allocation for the steady cash dividend payments. Thanks for all the resources and info. Cheers
Chris, thanks for your kind words. Glad to hear the Drawdown Strategy link was timely for you. Hope all is well in your corner of BC, loving your photographs!
I’m still 20 years away from the starting line. I’m looking forward to the next bear so that I can take advantage of some Roth conversions. I have too much tax deferred savings at the moment. Trying to follow the “begin with the end in mind” mantra.