There has been a lot of talk about whether the stock market is in a bubble. As usual, there are distinguished professionals on both sides of the debate, armed with convincing statistics and arguments. So, what is the average investor to do? We do what we usually do: try to understand the facts of the situation. Let’s start by asking ourselves what a bubble is, as this is the unavoidable first step in deciding whether we are in one.

Bubble Defined

There are multiple definitions. The essence of them all is that asset prices have gotten to an unsustainably high level, driven by ridiculously positive expectations on the part of investors, and that when those expectations change (for whatever reason), prices will revert to something normal, dropping a lot in the process. If you think back to the dot-com boom and the housing boom, you see that this definition captures both very well.

Let’s start with the root question: are stock prices at an insanely high level? Almost every price-based indicator says yes. Whether you look at sales, book value, earnings, or any price-based metric at all, stocks are not only incredibly expensive but close to as expensive as they have ever been. For many analysts, this fact closes the case.

Interest Rates and Stock Prices

There is, however, another way to look at stock valuations, and that is to compare returns instead of prices. This approach acknowledges the fact that stocks do not stand alone in the financial universe but, rather, compete with other assets—specifically, bonds. The more bonds are paying in interest, the more attractive they are compared with stocks. For an investor, there is, therefore, a direct relation between interest rates and stock prices.

Think about it. Over time, the stock market has returned around 10 percent per year. If you could buy a risk-free U.S. Treasury bill giving you the same 10 percent, wouldn’t you buy that instead? Why take the risk involved with stocks if you don’t have to? And that investor aversion would push stock prices down until the expected return was enough to compensate for the risk. Interest rates up, stock prices down.

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