There has been a lot of talk in the markets lately about whether we are in a bubble. Much of that has focussed on AI shares like Nvidia and Palantir Technologies. But could there be bubbles elsewhere in the market? Rolls-Royce (LSE: RR) shares have stormed ahead in recent years, with the price up 1,039% in just five years, for example.
Might that be a bubble?
This FTSE 100 share’s had great momentum
On the moon, it is impossible to see how the moon looks in the grand scheme of things. That requires distance.
A bubble can be the same: hard if not impossible to spot up close.
There is one key difference, though. The moon has weak gravitational pull. When a stock bubble bursts, it often demonstrates rapid gravitational pull – and not in the direction investors want!
As an aeronautical engineer, Rolls knows more about gravity than most of us. The stunning rise in Rolls-Royce shares over the past five years has reflected a dramatic turnaround in its business performance.
But the ongoing strong performance has fuelled the share’s momentum. I see that as a risk, because if the business suddenly starts to underperform compared to expectations, that momentum could fade and the share price could come crashing earthwards even if the business itself performs okay.
A shifting landscape could affect the growth story here
At 44 times earnings, Rolls-Royce shares look expensive to me. The valuation looks even less attractive if earnings fall.
Such a fall could happen because of a sudden slowdown in civil aviation demand. That happened during the pandemic, bringing the business to its knees.
I reckon there is a fair chance that the current war in the Middle East could also badly hurt Rolls’ civil aviation business.
Passengers may well be less willing to fly. High oil prices might mean airlines have less spare cash to spend on new planes and engines.
If that happens it could stop Rolls-Royce from hitting its ambitious financial targets. I think it would be very bad for the share price.
More than one type of bubble
Still, does that mean Rolls-Royce shares could be in a bubble?
There are different sorts of bubbles.
One is where a company has little real value and gets massively overpriced. I do not see Rolls-Royce in that mould. It is a large, proven player in an industry with high barriers to entry. It benefits from a sizeable installed base of engines and proprietary technology.
Another type of bubble is where a business is good (or even brilliant), but the share price gets carried away with itself. I do see a risk that Rolls-Royce shares might be in a bubble of this type.
They already look expensive to me based on current earnings.
The prospective valuation looks better, given the firm’s goal of increasing earnings. But given the risks to civil aviation demand, I reckon there is a real risk that earnings could fall.
In that case, even if the company still performs decently — just not as well as hoped — investor confidence would be shaken. I reckon the share price could tumble in such a scenario.
At the current price, in today’s geopolitical climate, I will not be investing. Fortunately, there are other shares I reckon look like terrific bargains.
