In a stock market bubble, prices are inflated, fragile, and liable to burst. Investors act irrationally, perhaps manically, and herd together to chase stock prices higher and higher. This is not to say investors buying into a bubble are unintelligent; Sir Issac Newton lost a fortune pilling into the South Sea Bubble in 1720, just before it popped. People seem to get swept up in a mass fear of missing out on the hottest prospect on everyone’s lips.
The early 2000s were notable for the bursting of the dot-com bubble. Companies that added ‘.com’ to their names, and some that did not, were trading at extraordinary prices. This, despite having little revenue and zero earnings. Of course, some companies did go on to eventually deliver much of what was expected in the dot-com boom. However, caught up in the mania, investors associated the Internet with success, with little regard given to the fundamentals of the company the .com was attached to.
Are stock markets in a bubble?
Stock markets have rallied after the Covid-19 crash. Some particularly tech-focused ones are priced higher than they have ever been, seemingly shaking the pandemic completely. Robert Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio takes a stock or index price and divides it by the average earnings over 10 years, adjusted for inflation. The US S&P 500 has a CAPE of around 15–16 on average. Right now, it is at 35. The only time it has been higher was at the heights of the dot-com bubble, when it hit 44.
According to Sibils Research, a data provider, the FTSE 100 has a CAPE of around 14, below its historical average, which suggests it is undervalued. Indeed, the FTSE 100 sits below its pre-crash highs. But before concluding there is a US bubble but not a UK one, I should point out that the FTSE 100 is notable for a lack of tech firms. Many tech-focused firms (think of online delivery and teleconference ones), have grown their current and expected revenues during the pandemic. The S&P 500 has many such firms.
Is the FTSE 100 boiling over?
The FTSE 100, on the other hand, has a fair share of financial and oil stocks. During the pandemic, oil demand slumped and is expected to dwindle as the economy decarbonises. Financial stocks have suffered from a decade of low-interest rates, which worsened during the pandemic. Low rates increase the value of non-financial firms. That might explain the differences between the UK and US indexes completely, but I am not sure.
History may not rhyme, but it does repeat, and some tech stocks’ rapid rise may be premised on little more than calling themselves tech stocks. Furthermore, investors appear to be herding together around common themes once again causing price distortions.
I do believe some sectors in some markets are frothy and would seek to reduce exposure to them. In a recent Financial Times article, a strategist at Citigroup pointed out that relative to UK bonds, the FTSE 100 looks cheap, and there is the low CAPE ratio to consider. I don’t believe the FTSE 100 is in a bubble. It appears to be a good place to look for opportunities compared to the more exuberant parts of the equities landscape. However, just as not all .com stocks turned out to be winners, not all shares in a cheap-looking index will turn out to be so.
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James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.