Is the Stock Market a Bubble?

A common thread through much of the market discussion in the past several months has revolved around the concept of a bubble. Many pundits use the term generally, arguing that the entire stock market is on an unsustainable trajectory that will ultimately lead to a catastrophic endgame not dissimilar to what befell Japan earlier this decade.

I think the doomsayers are barking at the wrong ghosts. They talk about bubbles and their catastrophes as though they come along about once every few years. Sickened by the continued strength of the U.S. bull market, they have decided to amplify their language without taking into account several facts, such as the impressive strength of the U.S. economy, the awesome market position held by U.S. companies in the most important sectors of the global economy, and the rarity of bubbles. In other words, bubble chatter has simply become a louder way for bears to cry wolf.

Essentially, the bubble theorists argue that the stock market has entered a mania phase. Moreover, they argue, the Federal Reserve and other policy-makers, not to mention thick-headed investors, have lost sight of fundamentals and reality and are moving pell-mell toward a cliff. Like most doomsaying theories, the bubble theorists have good ammunition. Historical valuations are very high and a sense that things will never get very bad pervades much of the investing mindset. Also, the recent thrill-ride for Internet stocks has only added to the bubble theorists arguments.

But are we really on a path to catastrophe? Has the Fed lost track of its senses? Are stock prices such that investors ought to consider alternatives rather than continue playing in this stock market?

As we digest the doomsayers thoughts, let’s go over what is really working, and why that lays a solid foundation for stocks. For starters, the U.S. economy continues to click along. Professional chin-scratchers, charged with keeping track of the economy’s future, have gyrated between warning about recession and warning about inflation-inducing growth for the past several years. During that time, the economy has simply chugged along at a steady pace without throwing off inflationary problems. We are seeing more of the same today. Late last year everyone nervously worried about recession, now we’re hearing about the dangers of runaway growth. The economy’s continued strength, which shows no sign of abating, acts as a very important underpinning to stock market values.

Activities overseas also contribute to the bullish view. U.S. companies dominate the high-tech sector, the most likely area of growth in the coming years. Also, when emerging markets stumble, two things happen. One, nervous money comes back into the U.S. stock market. Two, U.S. companies, enriched by that movement of money and the strong stock market, are better positioned to swoop into these regions and establish dominant positions while local competitors suffer. This explains why troubles in Brazil and Asia have translated into good news for U.S. stocks.

Finally, bubbles are exceedingly rare. The Japanese example, oft cited by the bubble theorists, is one of these rare occurrences. But let’s give that experience a cursory glance. Real estate prices, usually a good indicator of how strange things can become in a bubble, grew to such astronomical levels that city blocks in Tokyo were worth more than entire cities in other parts of the world. That kind of real estate disparity has no corollary in the U.S. In addition, the fundamental valuations given to Japanese companies dramatically outstripped the nation’s economy. The U.S. has a very large, very dominant economy, something that the Japanese never came close to possessing, yet our fundamental valuations are not anywhere near the eye-popping levels achieved by the Japanese in the early 1990s.

There’s much more to discuss, especially the impact of the Internet. But I’ll let you come back at me before we get into that issue. Suffice it to say, while pessimism may be warranted in some sectors of the stock market, the concept of a bubble scenario is all flat.