Bubble Watch: The Valuation & Sentiment Signs to Look For

In recent posts, I have made the case for why U.S. equitiesare not in a bubble, noting that valuations are still far from past peaks.

That said, given the relentless rise in U.S. stocks, it’s hard to argue with the fact that certain market indicators, including a few valuation metrics, are flashing yellow.

To gauge when (and if) the market has officially tilted into bubble territory, I would suggest that investors focus on two sets of data: valuation and sentiment.

    1. Valuation. My main argument against a bubble in U.S. equities is that while valuations are no longer cheap,they are a far cry from previous peaks. However, some measures – notablythe Tobin Q Ratio, gross domestic product (GDP) to market capitalization, andthe Cyclically Adjusted P/E– are high, arguably too high.

I would pay particular attention tothe Shiller P/E Ratio, which is a variation on the Cyclically Adjusted P/E or CAPE. This indicator is worth watching as it has historically correlated with long-term stock market returns. Today’s reading, in the mid 20s, suggests below average returns in coming years. A further advance would suggest a more serious problem. By way of comparison, the indicator reached a high of around 30 prior to the 1929 crash and was close to 45 in 2000.

2.Sentiment. While valuation is important, investors should also pay attention to sentiment. The goal is to gauge how – to steal a phrase – “irrationally exuberant” investors have become. In measuring sentiment, investors should focus on two types of indicators: what are investors doing and what are they thinking.

While there are dozens of different indicators, I’ll focus on two:put/call ratiosand Bullish/Bearish Sentiment. The put/call ratio is a short-hand proxy for positioning among options traders. Lower readings correlate with more bullishness. The ratio was 0.48 at the end of November. While this is modestly below average, it is a far cry from the lows of early 2000. In other words, options investors are positioned bullishly, but not excessively so.

A second measure to watch isa survey conducted by the American Association of Individual Investors (AAII). The survey tracks the percentage of self-described bulls and bears. As of the end of November, the percentage of self-described ‘bulls’ was slightly more than 47%, while those characterizing their views as ‘bearish’ was at 28%. Again, both metrics suggest bullishness, but not craziness.

The bottom line is that there is no one indicator that will definitely answer the question: Are we in a bubble? Investors need to piece together a conclusion based on multiple measurements, using metrics about both valuation and investor behavior.

For now, the preponderance of the evidence still suggests that stocks are not so overvalued, nor investors so exuberant, as to justify the ‘B’ word just yet.

Source: Bloomberg

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