Are Stocks in a Bubble?

| September 09, 2020

The last week has been the first period of significant volatility after the bear market crash in March, it is natural to wonder whether this is the beginning of a more severe market correction. Given the recent outperformance of technology stocks in particular, perhaps it's even starting to feel like a repeat of the late 1990s/early 2000s dot-com bubble.

One major reason you will often hear this comparison drawn is because of a valuation metric called the Price-to-Earnings ratio (see below). It indicates that the current S&P 500 price is trading at 23 times next year's estimated earnings. As the chart shows, this is the highest level since the Dot Com Era. Keeping in mind the old investing adage, "Buy low and sell high", this on the surface would indicate a bad time to be invested in stocks.  

The problem with that analysis is that it looks at stocks in a vacuum. In reality, investors need to constantly compare all assets on the risk spectrum: from stocks to cash and everything in between. The 10-year Treasury bond is a good proxy for an asset that is risk-free. Currently, the 10-year Treasury only pays investors 0.69% (see below). Sure it's risk-free, but it's nearly return-free as well. 

At the peak of the Dot Com Bubble, treasuries offered a 6-7% yield to compete with stocks, which made the Dot Com P/E metric all the more absurd, in hindsight. Today, treasuries offer less than 1%, making the current P/E multiple much less comparable to the Dot Com period P/E multiple. While earnings have catching up to do with the current price of stocks, the bubble comparison to late 1990s is not warranted, in our opinion.  Having said that, we expect market volatility to pick up as uncertainty over the election and a vaccine remain the key sentiment drivers.