David R. Henderson  

Why Should We Worry About Stock Bubbles?

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A number of commenters on my proposed bet with Bob Murphy seem to have missed the point. Rather than respond to each of them in comments that I know few people will read, I'm responding here.

Various people have argued that my proposed bet isn't much of a bet because a 10% fall in the S&P 500 over 5 years is not exactly stellar performance. True, it's not.

But that gets us to why we should worry about stock bubbles. When I read Bob's original post, I thought that I would worry if the S&P 500 were to be much more than 10% lower 5 years from now. Why? Because, as I mentioned in my previous post, a substantial part of my wife's and my net worth is in stocks. If I thought that stock prices would be, say, 25% lower 5 years from now, which is about the time I would need to start drawing on them for retirement income, that would be a big worry. If stock prices were, say, 9% lower 5 years from now, that would not be a big concern. This is not just a dry theoretical issue to me: I'm betting a substantial portion of my retirement income on the stock market.

Note also, by the way, that if the S&P 500 were 9% lower 5 years from now, I would probably have a higher real value in my stocks than I have now, even without putting any new money in. The reason: with the mutual funds that I own, the dividends are re-invested in the stocks. With dividends of only 2% per year, I would probably come out ahead.

A number of other commenters, both here and on Facebook, pointed out that the S&P 500 could easily fall by more than 10% sometime between now and 2020 and then recover. They argued that, therefore, I was proposing a "one-sided" bet. They missed the point also. Sure, the S&P 500 could fall by more than 10% between now and 2020. But that gets us back to why we--or at least I--care. I care because I'm a buy-and-hold person, investing for the long run. I don't care much what happens in between as long as it's close in 2020. If you're a long-term investor, you shouldn't either. Such a fall before 2020 would matter only to people who want to use the funds before 2020 or to people who try to be "market timers." I NEVER try to be a market timer.

Here's what can go wrong if you time really badly:

For instance, if an investor stayed fully invested in the S&P 500 from 1993 to 2013, they [sic] would've had a 9.2% annualized return.

However, if trading resulted in them missing just the ten best days during that same period, then those annualized returns would collapse to 5.4%.

Missing these days do so much damage because those missed gains aren't able to compound during the rest of the investment holding period.


When these issues come up in my class in our 5-minute discussions, I summarize this point by saying, "I'm too dumb to be a market timer. And so, probably, are you. But I'm smart because I know I'm dumb."

Other commenters wrote as if they think that whenever prices fall, they will automatically bounce back. That certainly didn't happen after the 1929 crash. Sure, the Dow-Jones Index got back to its 1929 peak--in 1954.

I remember my mentor and editor at Fortune magazine, the late Dan Seligman, dealing with this issue after the DJI fell by 22.6% on black Monday, October 19, 1987. A huge percent of his 401(k) was in stocks. When I called him in the next few days to discuss one of my book reviews for him, he told me that he was retiring at the end of the month. I was surprised. He seemed to love his job and his "Keeping Up" column was one of the most popular parts of the magazine. He was only 63.

He explained why he was retiring. Under Time Inc.'s 401(k) plan, when you retired, you could cash out at the value of your portfolio at the end of the preceding month. Retiring at the end of October would, he calculated, save him from a loss of a few hundred thousand dollars. And remember that this was in 1987 dollars. He managed to negotiate to keep his column for a while, but he was not a full-time employee any more and lost a good bit of his power in the organization. I think he missed it. Of course, as we know now, stock prices recovered relatively quickly. Had he known that, he would not have retired at such an early age. But you can't know that stocks will bounce back. If you could, you would not worry about "bubbles."

One final point. One commenter used language that I often see used to describe a fall in stock prices. He called it a "correction." The language is misleading. It implies that prices were above their value based on fundamentals and so the drop takes the price to its correct value. But we don't know the correct value. Moreover, if falls in price that take stocks to their "correct" level are a "correction," then we should also say that increases in prices of "undervalued" stocks are a "correction" also.


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COMMENTS (18 to date)
Kevin Erdmann writes:

What's so frustrating about the large number of people who treat financial asset prices as perpetually unreliable is that their models are not falsifiable. They say if the stock market is higher, even in 2020 or after, it's just going to be another bubble. This has been their explanation now for 20 years. If market prices aren't informational, then we have no measure to falsify with.

What's funny is that they act as if asset values are some crazy, irrational monster, moving wildly with fear and greed. But equities are actually pretty boring, in terms of aggregate valuations. In terms of asset values relative to real cash flows, they are much more stable than bonds. It's just that they take on most of the cyclical risk. They are a product of nominal profit levels and real growth expectations. Growth expectations fell in the 1970s (partly because we had actually loose monetary policy then) and they were high in the late 1990s (when we were inventing the internet). But, generally, including now, real growth expectations are 2-4% which is the very long term trend. The volatility comes mostly from volatile nominal GDP, of which profits take the brunt of the shock because wages and interest payments are inflexible. So, they are convinced there is a bubble, and since a negative NGDP shock is the only sure way to destroy equity markets, that's basically the only policy that will make them happy.

Kevin Erdmann writes:

In the graph in my link, set the beginning date to about 1958 for the trends to line up in Fred, so that you can see that about 80% of the time, including now, equity values and profits move predictably together.

John Hawkins writes:

On the story about Dan Seligman... wouldn't cashing out be an amazing deal, because he would have an extra few 100,000 that he could reinvest at the lower price???

David R. Henderson writes:

@Kevin Erdmann,
Good points. Thanks.
@John Hawkins,
On the story about Dan Seligman... wouldn't cashing out be an amazing deal, because he would have an extra few 100,000 that he could reinvest at the lower price???
No. You missed the point. It looked like a good deal because he got a few extra hundred thousand. Period. Remember that we know only with hindsight that the prices of stocks rose again shortly thereafter.

Borrowed_Username writes:

Even people we give credit to for "calling" bubbles are not really correct. The famous "Irrational Exuberance" quote from Greenspan took place on 12/05/1996 when the Nasdaq 100 was around 825, the lowest price reached from that time to present was 804, not a great result, but considering he was basically saying stocks were overpriced, not very impressive. Also overall returns from then to today when we're over 4500 were quite reasonable at about 8.8% annualized even with a huge spike in prices and reversal.

This was after the nasdaq had basically rallied for 6 straight years without any 10% price decrease in that time.

David R. Henderson writes:

@John Hawkins,
Oops. Now I see your point. My guess is that he valued the loss more than the gain and so would have rather kept his job. That seemed to be the way he talked. Also, I don’t know what he did do with the funds.

Felipe writes:
A number of other commenters, both here and on Facebook, pointed out that the S&P 500 could easily fall by more than 10% sometime between now and 2020 and then recover. They argued that, therefore, I was proposing a "one-sided" bet.

They have a very weird definition of bubble. A bubble does not mean that prices fell a lot. It means the price was irrationally high. If the price falls and then (rapidly) recovers, you can hardly say there was a bubble. If anything, you can say that the price was irrationally low for a while!

Brendan Riske writes:

My comments revolve around one major theme, don't project too much on the past performance of the stock market.

These articles obscure the truth with a few averages. Average S and P performance looks great, especially if you know how to dice the numbers. The truth is the stock market has been propped up by the fed since Greenspan was chief. He explicitly targeted index levels as a measure of his success. The bull market since then (in general terms, obviously there have been downturns but he started the endless climb higher) has been epic, but it is built on the fed and its put. This comes in the form of cheap financing directly from the printing press, low interest rates, and favorable bailout deals. No one has been really punished by the markets for the failures of 2000, or 2008.

stocks are supposed to be claims on future earnings or enterprise value. Mathematically stocks are overpriced today. The expectations of growth and returns are very high. Do you see a period of high growth and earnings ahead? if you do we are looking at a very different global economy. If they are mispriced, why are stocks being purchased? for a number of reasons. 1) many are bought with other peoples money through large funds 2) even people worried about stock valuations don't have many other places top use their money to get a return 3) just like with houses many people assume the stock market will always climb higher 4) buybacks of company stock which now make up a huge percentage of stock purchases, done entirely for short term gain at the expense of the enterprise long run.

You SHOULD worried about what the market is, and how long it will keep going up. There is no reason to think stocks should gain in value naturally unless the businesses they represent are growing or earning more. Economic activity in the US and abroad is slowing down, will slow down more, and needs to in order for us to sustainably inhabit the earth. Most major companies and countries are piles of unpayable debt. That is the long run reason why you will lose this bet. No one can ride the asset appreciation ponzi scheme ride forever

Roger McKinney writes:
if the S&P 500 were 9% lower 5 years from now, I would probably have a higher real value in my stocks than I have now

Not likely. 2% inflation will eat up your 2% dividends, so a market 9% lower than today would mean your real wealth will be lower.

Ben Stein wrote an excellent little book "Yes, You Can Time the Market" in which he showed how investors can earn much higher returns by following a simple moving average and buying only when the market is below the MA or buying when it is low and selling when the market is above the MA. Of course, it has to be a long term MA. He used 15 years, but it could be 7 or 10.

I show on my blog how to use the Austrian business cycle theory to time the market and talk about other Austrian followers in finance who do the same thing, such as Spitznagle who wrote the "Dao of Capital."

Yes, buy and hold works much better for most people because they know nothing about business cycles. Most investors and corporations buying back their own stock tend to buy at the market top and sell at the bottom. But you can make so much more with a little bit of understanding of the ABCT.

It's really as simple as this: the stock market response to profits; profits follow the business cycle. Get into stocks with both feet in the depths of a recession and get out when a recession appears immanent. BTW, the signs are that we are in a recession now and the NBER will inform us of it in about six months.

Gene Callahan writes:

You need no 'sic' on singular 'they': it is a perfectly natural and acceptable usage:

https://motivatedgrammar.wordpress.com/2009/09/10/singular-they-and-the-many-reasons-why-its-correct/
http://languagelog.ldc.upenn.edu/nll/?p=4475

It was used by Chaucer, Shakespeare, Dickens, Austen, etc. etc.

Gene Callahan writes:

@Roger McKinney: "Not likely. 2% inflation will eat up your 2% dividends, so a market 9% lower than today would mean your real wealth will be lower."

The bet is on inflation-adjusted stock prices.

Whenever you think smart economists have ignored so obvious a point, re-read.

Thucydides writes:

Little discussion here about the unprecedented way the Fed and other central banks have inflated asset prices to very high levels by a number of measures, levels only previously seen near major market tops. On the other hand, there is the risk that this action will set off serious inflation, and instead of securities prices falling, they blow off to the upside. The market has become a dangerous casino, and is no longer a mechanism for allocating capital or pricing out risk. Everything is highly distorted, and vulnerable to severe shocks. You can't risk being out of stocks, and you can't risk being in them. Old folks who saved and used to live on safe interest from bank CDs now get nothing, and are forced into the casino. All this is not likely to end well.

David R. Henderson writes:

Thanks, Gene Callahan, on both.

blink writes:

David, you bring up several good points about whether we should worry about bubbles. To the extent that Bob Murphy or others are claiming the sky is falling and we need to take action, this is entirely relevant.

But there are two possible claims: (a) we in a bubble; and (b) we should worry about it. You compellingly refute (b). If you also disagree with (a), then the terms matter.

By comparison, I might claim that the St. Louis Cardinals record is a "bubble" (currently 32-16). The terms you propose to Murphy would be like even odds on the Cardinals finishing in last place in their division. However, I would call the "bubble" claim valid if the Cardinals even miss the playoffs.

Kevin Erdmann writes:

The problem David faces in coming up with terms is that even though the bubble talk is baseless, there are 101 other reasons that the stock market could decline. One of those reasons is that toxic monetary policies proposed by the bubble police will be enacted.
We had a huge contraction in 2008, but that did nothing to end the bubble debate. And the subsequent recovery didn't either.

David's main hope, as with the inflation bet is that Bob's model pushes him to accept terms that are unlikely.

Glen writes:

If you're counting on spending your stock holdings at some point in the future, then you're a market timer whether you like it or not. Your target date of 2020 is already not far off, and as it gets even closer, equity market volatility will become an increasingly large factor in your retirement quality of life.

If you truly “don't care much what happens in between [now and 2020] as long as [the value of my portfolio] is close [to today] in 2020,” then you should soon begin selling your equity holdings and putting your money into fixed-income investments that do not carry interest rate risk. Your choice to stay fully invested in equities is an explicit timing bet that any corrections that do occur in the next five years will be mild and/or will occur soon enough to allow time for a substantial recovery.

Brendan Riske writes:

The problem we face again is that Kevin Erdmann doesn't know what a stock bubble is. We have seen 2 huge ones in a decade and a half, did you miss that? Did you miss the ridiculous tech valuations? the nonsense in the housing market? How do you not see that we are on the cusp of that again.

There is such thing as waste and malinvestment, and that is what this central bank driven bubble has done. The fact that you don't recognize that baffles me. You sound like Gartman or Liesman.

Kevin Erdmann writes:

I feel like I'm John Malkovich in "Being John Malkovich" except, instead of my name, everyone just keeps saying "bubble".

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