Recent rumors from the latter camp point out that the stock appears overvalued by the standards of none other than Warren Buffett. The so-called Buffett Index compares the market capitalization of all U.S. stocks (stock price x number of shares outstanding) with the quarterly output of the U.S. economy.
If the total value of the Wilshire 5000 index (which measures the market as a whole) is roughly equivalent to the latest quarterly GDP estimate, then the situation is in normal territory. When stock prices reach around 70% of GDP, stocks are said to be undervalued. Stocks trading at around twice the size of the economy are considered a major red flag.
As of late, this ratio has been around 190%, the highest level in two years. In calendar year 2022, the last time stocks traded in the region, the S&P 500 index fell 18%.
Is it time to prepare for the shock? Liz Young, head of investment strategy at SoFi, says it’s not there yet.
“If you compare the bubble to the late ’90s and early 2000s, no, this is not a bubble,” she says. “We’re stretching valuations, but it’s not outrageous or off the charts.”
Hear from the pros on the current state of the market and what it means for your portfolio.
If you stay in the market long enough, you will eventually see the bubble burst. This occurs when investors bid up the price of an asset and the valuation becomes decoupled from historical norms and underlying fundamentals. Once everyone realizes they’re off their skis, they start taking profits, prices fall, panic sets in, and asset values plummet.
Buffett’s favorite indicator is a flashing signal to investors that stock prices are in volatile territory compared to historical norms. But if you dig deeper into what’s driving stock prices up, you’ll find that the current rise in stock prices isn’t just a product of investor enthusiasm.
“The stock market rally we’ve seen so far has been driven by earnings growth,” said Gargi Chaudhry, chief investment and portfolio strategist for the Americas at BlackRock. “If we hadn’t had this kind of revenue growth, I might have been more open to the idea of a bubble.”
In other words, stocks are doing well because the underlying companies, especially large, high-quality tech companies, are driving up profits.
“The most profitable companies are doing very well. They are not speculative,” Chaudhry said. “The fact that earnings growth continues to drive earnings is very reassuring to me, and should be for investors as well.”
In many ways, the economic picture is also rosy.
“GDP growth remains strong, and consumer spending and revenue growth is healthy and above expectations,” Young said. “The labor market remains strong and inflation has probably plateaued, but it’s not all the way back yet. I think that’s the fundamental bull case.”
Nevertheless, she sees some cracks on the surface of the economy. While the above factors indicate the economy is in the midst of a bull cycle, other indicators make it appear as if it is nearing an end, Young says.
For example, the longest inverted yield curve in history and the remarkable rise in gold prices seem to indicate that some investors are losing faith in the economy.
Young said he doesn’t see alarm bells ringing yet, but the Fed still walks a difficult tightrope as it plans to cut rates this year without reigniting inflation concerns.
“When we go back to recessions and downturns, you’ll see headlines about the Fed hitting a soft landing,” she says.
Chaudhry’s outlook for the stock market for the rest of the year is even more bullish, but he says investors shouldn’t expect strong results over the next nine months.
“We’ve had an incredible performance over the last few weeks. Will there be a moment or a period of pullback in the stock market? There absolutely will be,” she says. “I’m not saying it’s going to go up from here.”
Nevertheless, Chaudhry says a diversified stock portfolio will continue to benefit from growth in corporate profits and U.S. economic output. With interest rates expected to remain relatively high, investors would be wise to focus on profitable companies with low debt, he added.
“Companies that perform well are the highest quality and most profitable.”
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