Dealing with market bubbles

Steve Merrell |

Q: I am feeling more and more concerned about the stock market. The economy continues to struggle because of the pandemic, but the stock market keeps going higher. Are we in another market bubble? I don’t think I can go through another 2008 again.

A: I know a lot of people are wrestling with this question right now, including some of the smartest investors in the market. To answer your question directly, yes, I believe certain parts of the market—tech stocks, in particular—have moved into bubble territory. However, the stock market is a very diverse place. Large parts of the stock market are clearly not inflating at the same rate as tech stocks. 

Some people define bubbles as sharply rising prices followed by a crash or a “bubble burst.” Personally, I find this definition unsatisfying for a couple of reasons. First, asset prices can rise sharply for a number of reasons, not all of which are bad. Second, according to this definition, you never know if you are in a bubble until after the bubble bursts. By then it is too late to do anything about it.

A better way to approach the issue is to evaluate a stock’s price relative to the company’s underlying economic value. You don’t really need to get caught up in the game of trying to decide if the market is in a bubble. If the market pushes a stock price far beyond levels warranted by its economic fundamentals, you should not invest in that stock.

That kind of discipline is tough to maintain when the market is moving and it seems like everyone is making money. However, discipline is essential if you hope to enjoy long-term investment success. If you lose your discipline, you are eventually going to lose your money.

The dot-com mania of the late 1990s provides many examples of this. It was a time when many stock prices became completely disconnected from economic reality. A good case study is Webvan Group.

Webvan was a grocery delivery business based in Foster City that promised to revolutionize the way consumers shopped for groceries. It wasn’t a new idea, but internet technology gave them an edge—or so they thought.

Venture capitalists loved the story and invested heavily. In November 1999, Webvan went public selling shares at a price that valued the company at nearly $5 billion. This was an amazing valuation given that Webvan had less than $1 million in sales and was racking up huge operating losses. In fact, the company bluntly declared in its SEC filing that it expected to produce operating losses “for the foreseeable future.”  The “foreseeable future” lasted until 2001 when Webvan filed for bankruptcy and went out of business.

While few stocks today are as completely disconnected from reality as Webvan was at the time of its IPO, there certainly are some that raise eyebrows. For example, although Tesla is a very interesting company and its products are terrific, the fact that its market cap is nearly 4 times that of Toyota, the largest car-maker in the world, should give you pause. When you dig deeper and see that Toyota’s worldwide sales are 844 times larger than Tesla’s and that Toyota’s net profit margins are more than three times Tesla’s, you realize that Tesla’s stock may have gotten a little ahead of itself.

So how should we deal with potential bubble stocks in our portfolios? First, you need to know the stocks you buy. If you don’t feel comfortable researching a stock, get some help.  But make sure you are talking to someone who knows what they are doing. Many brokers are better at sales than stock analysis.

Second, if you look through your holdings and find a stock that seems disconnected from reality, take your profits and move on. Your ability to do so will keep your portfolio fresh and your thinking clear.

Finally, make sure your portfolio is prepared for market volatility. You can do this by making sure you are well-diversified into high quality assets. Make sure also that you have enough invested in bonds and cash to meet your expected withdrawals for the coming two to four years.

 

 

Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to smerrell@montereypw.com.