Deciphering the Bubble Conundrum

• All three major US stock indexes are showcasing robust gains in the past year, igniting debates on the existence of a possible market bubble formation. Comparisons to mythical creatures like Bigfoot or UFOs notwithstanding, the current trajectory of the US stock market does not seem to align with historical bubble indicators.

Market Dynamics vs. Economic Realities

When delving into the realm of bubbles, it becomes crucial to define what exactly constitutes a bubble. The common industry definition alludes to a scenario where participants inflate stock prices beyond their fundamental value, as determined by some system of stock valuation. Yet, the nuances and intricacies of this definition raise eyebrows.

• The blurred line between “market” and “economy”—two entities that rarely align perfectly.
• The ambiguity surrounding the concept of “some system of stock valuation,” questioning the reliability of metrics like the price-to-earnings ratio.

Equities vs. Commodities: Spotting the Bubble

While identifying bubbles in the commodities market is relatively straightforward—the detachment of futures contracts from their intrinsic worth—equity markets pose a more complex challenge. Unlike the clear signs in commodity markets, equity bubbles are not always obvious, except in instances such as the meteoric rise of meme stocks.

What defines meme stocks? These are shares of companies that gain unwarranted popularity driven by social sentiment rather than tangible value. These equities often lack substantial earnings or purpose, akin to frivolous cultural phenomena like the Kardashians or sensationalized social media trends. The ensuing frenzy sees prices artificially inflated, setting the stage for an inevitable burst.

However, the bubble debate extends beyond individual stocks to encompass the broader stock market landscape. While some argue against the existence of bubbles in equities due to the absence of a definitive intrinsic value system, the reality of market manipulation—from social media antics to political influences—cannot be ignored.

Recent polls reflecting market sentiment indicate a divided opinion on the presence of a bubble in US stocks. The uncertainty surrounding bubble detection, much like a hidden “Black Swan Event,” underscores the challenge of preempting market upheavals in the absence of a concrete metric for intrinsic value.

A Closer Look at Index Performance

As of February’s conclusion, the major US stock indexes continue to showcase remarkable growth:

• The S&P 500 hit a monthly high of 5,111, closing at 5,096—an almost 5% monthly increase and a staggering 28% surge from the previous year.
• The Dow Jones Industrial Average reached a new pinnacle of 39,282 before settling at 38,996, marking a 2% monthly rise and a 19% annual increase.
• The Nasdaq came close to its record high at 16,212, ultimately closing at 16,092 with a 6% monthly upturn and an extraordinary 40% surge over the past year, achieving its highest monthly closure ever.

The data analysis from DataTrek highlights that while the indexes have experienced significant growth since February 2021, none have breached the 100% mark historically indicative of an impending bubble.

My evaluation sways towards a belief that the US stock indexes are not currently in a bubble, given the sustained upward trends since the latter part of October 2022. The potential for bubbles to materialize hinges on one’s faith in the concept of market bubbles within US equities. As the famous market adage goes, we often only recognize bubbles after they burst. I’ll adhere to Newsom’s Market Rule #1: follow the trend and remain vigilant for clear reversal signals akin to those witnessed at the close of January 2022 across all three major indexes.

Please note that the author, Darin Newsom, has no direct or indirect positions in the securities discussed. The contents of this article are purely informational. For further details, refer to the Barchart Disclosure Policy.