published Tuesday, November 19th, 2013

Despite surge, many don't see a stock bubble

  • photo
    A board on the floor of the New York Stock Exchange shows the Dow Jones industrial average above 16,000 on Monday.
    Photo by Associated Press /Chattanooga Times Free Press.

The Dow Jones industrial average has surged 900 points since early October and crossed the 16,000-point threshold Monday. IPOs are hot again. Small investors, stirred from their post-recession daze, are coming back to stocks. And it's been more than two years since the market has had a significant slump.

Those trends have raised concerns of a stock bubble. They shouldn't, money managers say, because even with the broader market's 26 percent jump this year, stocks aren't overpriced yet.

"Stocks are not cheap, but that does not mean that the stock market is expensive," says Russ Koesterich, chief investment strategist with Blackrock.

The ratio of stock prices to projected profits for companies in the Standard & Poor's 500 index is 15, according to data from FactSet. That's slightly below the average of 16.2 over the last 15 years and far below the peak of 25 in late 1990s and early 2000s.

Underneath the rally, most of the fundamentals of this market remain solid. Corporate profit margins are near historic highs and profits are expected to keep rising. There are no signs the U.S. economy, which is still recovering from the 2008 financial crisis and Great Recession, will slip back into a downturn.

All that leaves investors with conflicting feelings. Few see the stock market as attractive as it was at the beginning of the year, but fewer see an alternative where they should put their money.

Bonds are down 2.1 percent this year, according to the benchmark Barclays U.S. Aggregate bond index. Cash has a near-zero return in money market funds. Gold has dropped 24 percent.

"It's hard to say stocks are expensive when you compare them to any other asset class," says Brian Hogan, director of equities at Fidelity Investments. "The other options are simply not attractive."

Bubble or no, there are some signs that stocks are getting pricey.

Individual investors have been returning to the market, often a sign that stocks are reaching their peak. Individual investors poured $167 billion into stock mutual funds this year, according to data from Lipper. In comparison, large institutional investors like hedge funds, pension funds, endowments and insurance companies have only put in $111 billion.

When stocks are valued using an adjusted price-to-earnings ratio developed by Nobel Prize-winning economist Robert Shiller, they seem even more expensive. Shiller's adjusted price-to-earnings ratio averages out the S&P 500's earnings over 10 years, to smooth out the volatility that comes from the booms and busts. Using Shiller's formula, stocks are currently trading at 24.4 times their previous 10 years' worth of earnings, well above the historic average of 16.5 going back to the year 1881.

A few Wall Street professionals remain bearish and think stocks are due to fall by 10 percent or more.

"I think a lot of what's driven the market higher recently is simply momentum," said Jack Ablin, chief investment officer with BMO Private Bank. Ablin thinks stocks are "10 to 15 percent overvalued" at their current levels.

Then there's the elephant that won't leave the room: the Federal Reserve.

The Fed has been buying $85 billion in bonds each month in an effort to keep interest rates low and stimulate the economy. Those purchases have pushed up bond prices and made stocks more attractive in comparison.

The Fed was supposed to start pulling back, or "taper" its purchases, in September. But the central bank surprised investors by voting to delay that move. It isn't expected to change course until early 2014, at the earliest.

Critics say the stimulus has driven too many people into stocks and inflated prices.

Janet Yellen, who has been nominated to lead the Fed starting next year, told the Senate Banking Committee last week that the Fed will keep a close eye on the issue, but said stocks "are not in bubble territory."

Still, now may not be the time to jump into stocks, at least in the U.S. Few investors expect the market's gains in 2014 to come close to this year's.

Analysts at Barclays Capital expect the S&P 500 index to reach about 1,900 by the end of 2014, roughly 6 percent above its current level. Analysts at Goldman Sachs are less optimistic. They see the index closing at 1,850 by the end of 2014.

Not all parts of the market are overvalued, according to some investors. Bank stocks are among the cheapest in the S&P 500, based on the ratio of their price compared to projected profits.

"Typically financials benefit from the next stage of a bull market," said J.J. Kinahan, chief market strategist with TD Ameritrade.

Energy and information technology stocks are also relatively inexpensive, when looking at price-to-earnings ratios. However, energy stocks have struggled due to lower oil and natural gas prices, so low stock prices may not necessarily mean they are a good value.

Blackrock's Koesterich says investors should also look outside the U.S., particularly to emerging markets. But don't focus on one country or continent, he said.

"Bring down your exposure to U.S. and go buy a broad international fund," he said.

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