Morningstar’s John Rekenthaler published a helpful column outlining the four signs of a stock market bubble. The good news is that the author does not believe investors have crossed over from confident to wildly speculative, so we’re not yet in a full-blown bubble. Unfortunately, however, we’re getting there.
The first bubble condition, low interest rates, is certainly a feature of current market conditions. The column mentions famed economist Hyman Minksy, who believed that low rates and easy money foreshadow asset bubbles.
Emerging technologies is the second characteristic historically associated with a market bubble. Mr. Rekenthaler makes specific reference to Tesla Inc., where he believes investors have ignored any traditional concepts of value. He writes, “Trading at 15 times revenues and 100 times its expected earnings, Tesla is the shiniest example of a stock that has benefited from confidence in the power of scientific advancements.”
“Investor amnesia” is the fourth sign of market excess. This is a condition where a new generation of investors, lured by rapidly climbing stock prices, ignore the market meltdowns of the recent past and become willing to pay any price (in terms of valuation levels like price to earnings ratios) to participate in rallies.
The final aspect of market bubbles is “new math.” The author describes this phenomenon as characterized by “unsustainable valuations, supported by arguments that changing economic conditions require a new form of investment math.”
For me, the most interesting form of new math concerns intangible assets – patents, intellectual property, proprietary software and brand value are a few examples. In the distant past, assets on corporate balance sheets were largely tangible - plants and equipment, for instance, that could be sold in the event of bankruptcy.
Intangible assets have come to dominate S&P 500 balance sheets. In 1985, intangible assets made up 32 per cent of U.S. balance sheets. This climbed to 68 per cent in 1995 and now stands at 84 per cent.
Unprecedented central bank intervention in major economies makes it very difficult to assess where we are in terms of the market cycle. As I’ve noted previously, extraordinarily low inflation-adjusted bond yields justify high price-to-earnings valuations to a great extent. This suggests that investors aren’t overpaying for equities even if valuations are elevated.
Mr. Rekenthaler’s column is worth reading in its entirety, not least because it reminds investors to reduce risk as signs of speculative fervour appear.
-- Scott Barlow, Globe and Mail market strategist
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Ask Globe Investor
Question: I started looking at dividend stocks because guaranteed investment certificates pay next to nothing. I understand that you hold stocks and reinvest the dividends, but do you ever sell them? For instance, I own Algonquin Power & Utilities Corp. (AQN) and Bank of Montreal (BMO), which are up about 28 per cent and 33 per cent, respectively, since I bought them. Given that much upswing, wouldn’t it be better to sell and take the large gain and then get back in again at a lower price (cross fingers) in four, six or eight months' time? It seems strange to not grab this big increase as it represents many years of dividend value.
Answer: I occasionally sell stocks, but only when the business has taken a fundamental turn for the worse. For the vast majority of stocks I own, I buy and hold and don’t try to sell at one price and get back in at a lower price, which is what you are suggesting.
If you knew that Algonquin Power was going to fall 10 per cent or 20 per cent over the next few months, then selling now and buying back later would make perfect sense. But you don’t know that. Nor do you know that Bank of Montreal – which is already down more than 20 per cent from its January high – will fall further. What if you’re wrong and both stocks rise?
You seem to be motivated by a desire to protect your unrealized gains, but the prices you paid for AQN and BMO are irrelevant. That’s history.
The only question you should be asking now is whether you like the future prospects of these companies enough to continue to hold them. Instead of trying to guess where AQN and BMO will be trading in five months, think about where they will be in five years. Both companies have a long history of growing their earnings and dividends and, while the coronavirus has created short-term uncertainty, as an owner of both stocks I suggest that you focus on the long term instead of engaging in a short-term trading strategy that may or may not work out.
What’s up in the days ahead
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Compiled by Globe Investor Staff