Many of us, having experienced recent financial bubbles – the Dot.com bubble in 2000 and the Housing bubble in 2008 – remain cautious about future financial bubbles. So are we heading into a bubble in the equity market now?

One of the most significant stock bubbles of all-time occurred almost 300 years ago:

“In 1711 the Earl of Oxford formed the South Sea Company, which was approved as a joint-stock company via an act by the British government.  From the start the new company was expected to achieve huge profits given the believed inexhaustible gold and silver mines of the region. It was anticipated the company would ship British goods to the South Seas where they would be paid for in gold and silver.  Sir Isaac Newton was an early investor in the stock, investing a decent amount of money into the shares.  He exited those shares a number of months later with a good profit, leaving him a happy investor. Subsequently, the shares soared into bubble proportions, and as Newton saw his friends getting rich, greed overtook fear and Newton took most of his cash and re-bought the shares. Not long after that, the share price peaked, and then crashed, leaving Sir Isaac Newton broke.”  (source: Raymond James)

“I can calculate the movement of the stars, but not the madness of men.”   . . . Sir Isaac Newton, after losing a fortune in the South Sea bubble

So are we heading into a bubble in the equity market now?  I don’t believe so but I am taking a cautious approach . (and  I am no Sir Isaac Newtown)

On the positive side, Corporate America is healthy from a balance sheet and profitability perspective.  Cash, as a percentage of assets, is at its highest level in 40 years.  Debt levels have come down as has interest expense due to refinancing at current low rates. (sources: Advisors Capital Management and Fidelity Investments).

The same is true for consumers, who have reduced and refinanced debt to a level of personal income not seen since 1983. (see chart below courtesy of Barrons)

On the negative side, investor sentiment is too bullish for my liking.  People are shifting from Fear to Greed as the current market continues to march higher.  I adhere to a Warren Buffett axiom for investing – “be fearful when people are greedy and be greedy only when people are fearful”.

 

With stocks, price is what you pay and value is what you get.  One way to measure value is the Price-to-Earnings ratio.  While corporate profits have continued to rise, the price to buy these earnings has risen at a faster pace.  As of November 29, 2013 the P/E ratio for the S&P 500 is 16, right on historical average.  For comparison, the P/E ratio for the S&P 500 peaked at 17.7 in 2007 and 28.4 in 2000, just before those bubbles popped, and hit a low of 13.5 in September 2011. (source: Yahoo Finance)

 

Interest rates have risen from a low of 1.40% on the US 10yr Treasury in July 2012 to 2.80% on 12/2/13 (source: Yahoo Finance).  This is putting a damper on the housing recovery in the US, which has been one of the bright spots in the US economy over the last 18 months.  This is the balancing act the Federal Reserve is trying to manage.  As the US economy gets stronger interest rates will naturally rise, but rising interest rates will slow down economic growth and reduce stock market values.

 

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Although information herein has been obtained from sources deemed reliable, its accuracy and completeness are not asserted. All opinions and estimates included in this report constitute the judgment of the financial advisor as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

 

Investing involves risk and you may incur a profit or a loss. Diversification does not ensure a profit or ensure against a loss. There is no assurance that any investment strategy will be successful.  Past performance is no assurance of future results.