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Are We in a Stock Market Bubble? What the CAPE Ratio Is Saying


The problem with bubbles is that you look silly if you don't jump in when they're happening, but equally foolish if you're caught in one when it bursts.

I have made it no secret that I think the stock market -- and especially tech stocks -- are in another Fed-induced bubble. Many point to the S&P 500 (INDEXSP:.INX) trading at 15.9 times 2014 estimated earnings as a sign that stocks are not that expensive despite their huge run-ups.

However, I have a problem with forward earnings. Fi they are very difficult to predict. Look at 2008 and 2009: If you have a huge downturn, those forward estimates go down the drain. For example, due to lack of top-line growth, many companies have downgraded earnings over the past year.

I like to look at the CAPE, or trailing 10-year P/E. Some say this is looking backwards, however I think it's a way to smooth out valuation over a defined period to see if stocks for the long term (three to five years) are cheap. It often works. For example, stocks at the 2009 bottom were trading at a CAPE of roughly 13 on the S&P, or their lowest level in nearly 20 years. This, of course, ended up being a great buying opportunity.

In the late '90s, the CAPE hit 30, and even went to nearly 40 times earnings at the 2000 bubble top. Stocks perfomrened miserably for the next nine years. Right now the CAPE, or trailing 10-year moving average, is at 25 times earnings. The US CAPE is actually the second highest in the world, with only Sri Lanka being higher (this makes sense as Sri Lanka is booming after emerging from a 30-year civil war).

However, if we look at the markets with the 10 highest CAPES (or trailing P/Es) in the world last year, we will see pretty mediocre performance. Seven of those 10 markets finished down. The average loss was just over 5%. The only market that was up more than 8% was the United States with a 33% gain. The two that had a CAPE of higher than 25 (Colombia and Peru) finished down 15% and 25% respectively. Therefore, the chance of a repeat performance in the S&P 500 is pretty small.

Then we have the huge bubbles in social media and dot-coms. It amazes me that with the mother of all bubbles occuring 13 years ago, we can see another one in the dot-com space less than half a generation later.

This brings us to the problem with bubbles. To paraphrase John Hussman, the problem with bubbles is that if you don't participate in them, you look stupid before they burst, and if you do, you look stupid afterward. That is it in a nutshell. All of us dummies who are laughing at the valuations of Tesla (NASDAQ:TSLA) and Twitter (NYSE:TWTR) as they soar upward look like worrywarts who don't get the growth stories. However, that perception changes after the crash, when the investors who bought the growth story watch stocks in the bubble fall 80-90%.

Right now I am content to sit on the sidelines. I own a small position in ProShares UltraShort QQQ (NYSEARCA:QID), which I am slightly up on -- even after today's Nasdaq (INDEXNASDAQ:.IXIC) rally -- as a hedge against another tech wreck.

No one knows when this bubble will burst. In 2000 the Nasdaq went from under 4,000 to over 5,000 in just the last two months of the bubble. No reason it can't do that again. However, when we come out the other side it will be very ugly.
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Position in QID.
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