The stock market has been on a tear lately. Since October 27, 2023, the S&P 500 is up more than 24%. Some high-profile stocks have performed even better.
Less than two months into 2024, Meta Platforms, parent of Facebook, Instagram, WhatsApp, and several other products and services, is already up over 37%. Meanwhile, the darling of chipmakers, NVIDIA, is up over 61%.
This recent surge has some pundits worried that this market could be overvalued or even have reached a “bubble” phase. However, a more in-depth look at the current environment suggests that there’s not an unusual amount of speculative activity.
Stocks are rising as fundamentals improve, a sign of a healthy market. It is always possible for the market to become overvalued, but there’s no clear reason to think that’s happening now.
What is a bubble anyway?
In my opinion, the term “bubble” has become vastly overused. It was coined to describe a market that acted like the bubbles kids blow out of one of those plastic wands: they don’t last long, are extremely fragile, grow on nothing but air, and once they reach a specific size, they suddenly burst.
That describes some past periods, two of the most obvious being the early 2000s tech bust and the housing market in 2007-2008. And, of course, no one can forget the “meme stock” and SPAC boom in 2020 and 2021. These were smaller examples of what I’d call a true bubble.
Yet, too often, people use the phrase “bubble” to describe any asset that has risen in price rapidly. I honestly think investors who weren’t adequately allocated often use it in the market as an excuse, saying things like, “It isn’t my fault I wasn’t invested... the market has gone crazy!”
Calling every bull period a bubble or deriding it as speculative excess won’t help you become a better investor. Moreover, it won’t contribute anything meaningful to the debate on where the market goes next. To that end, the term “bubble” should only be reserved for special situations.
Core fundamentals are very good
A few interrelated factors have driven stocks higher in the last few months.
The first is that inflation has subsided, but job growth has remained robust. This has given markets more certainty about the path for interest rates, resulting in a substantial decline in recession risk.
Lastly, company profit growth has picked up over the last two quarters, with companies selling more volume of products, not just raising prices like they did in 2021 and 2022. This has investors believing the surge in profit growth is probably more sustainable. In particular, profits among tech companies have been especially strong. This is partly due to a rebound from weakness in 2022 and a new surge in spending on AI-related projects.
So, what we’ve seen is that the significant risks everyone feared in the last couple of years are fading at the same time, and some new opportunities are emerging. Given this, it is no wonder stocks have risen substantially.
Speculative activity
We also aren’t seeing the typical signs of speculative behavior that would lead one to believe this market rally is unsustainable. In fact, it is remarkable how little speculative behavior we are seeing, given how strong the market has been recently.
For example, consider the market for initial public offerings (IPOs), which are stocks listed on an exchange for the first time (going public). According to Bloomberg data, in 2021, there were almost $143 billion of such transactions. In 2023, that was just $13 billion, and so far in 2024, we’re on pace for about $18 billion.
Source: Bloomberg
We’re also not seeing stocks bought with borrowed money (on margin). Based on FINRA data, only about 1.4% of US stocks are currently owned on margin. That is lower than any time from 2005 to 2022.
You may hear about tiny companies with spectacular returns, such as Super Micro Computing stock, up over 200% year-to-date through February 23. These examples make for good stories, but it isn’t unusual for any up-market. Fourteen companies have doubled in price so far this year. Through the first two months of 2019, there were 21.
We say all of this to drive home a point: we just aren’t seeing the kind of widespread speculation that suggests an unsustainable market rally. Our original point that economic fundamentals are driving stocks higher explains the recent market best.
“Magnificent 7”
A lot of attention has been put on the so-called “Magnificent 7,” which is a group of stocks with an extremely strong 2023 that has mostly continued into 2024. Specifically, those companies are Amazon, Alphabet (parent of Google), Apple, Meta Platforms (parent of Facebook), Microsoft, NVIDIA, and Tesla.
Some commentators argue that because these seven stocks have been so dominant over the last year, it is a sign that stocks generally aren’t so healthy. Rather, these few stocks, most of which have some tie to the AI boom, are the only ones keeping the market going.
It is true that these seven stocks have been on a decisive run. Combining 2023 and YTD 2024, the Russell 3000 (an index that covers both large and small US companies) is up 33.6%. This group accounts for 17% of that return. In other words, the other 2,993 stocks contributed a little less than half of the market’s return over this period.
However, this glosses over the fact that all seven stocks were down sharply in 2022. If we measure each stock from the end of 2021 to today, only three have outperformed the S&P 500.
Source: Bloomberg
The chart shows that while these stocks were hot in 2023, a lot of that was a rebound from a weak 2022. And to reiterate our first point about fundamentals, most of these stocks saw weaker profit growth in 2022 and the start of 2023 and have rebounded since. So, the pattern of performance over the two-year span fits the fundamental story.
In the year 2000
It is also interesting to compare these stocks to the 1990s tech bubble. One way to compare the value of different stocks is to look at the price-to-earnings ratio (P/E). PE is just today’s stock price divided by its profits per share. Analysts typically use the estimated profits for the following year, sometimes called the “forward P/E,” to measure profits.
A higher P/E ratio means you are paying a higher price per dollar of profit for that company. When people say the stock market is expensive (or even overvalued), the P/E ratio is very often what they’ll cite as their reason why.
The chart below compares the P/E ratio and the prior two-year return of the Magnificent 7 vs. the seven largest NASDAQ companies at the tech bubble’s peak in March 2000.
Source: Bloomberg
As this chart shows, there’s really no comparison to the 90s tech bubble.
The average P/E of the top 7 companies in 2000 was almost 90. That means the Magnificent 7’s price would have to triple to surpass the valuation these stocks traded at in 2000.
And for the people who think the recent returns on these stocks are red hot, look at what happened in 2000: the group averaged over a 160% return annualized over two years.
Now that’s what a bubble looks like.
Valuation doesn’t predict future returns
Perhaps the most important point here is that the mere fact that the market has recently risen doesn’t indicate anything about where it goes next.
When the stock market goes up rapidly, it is usually because there has been good news. When the P/E ratio gets to be higher than average, it is usually because economic conditions are better than average. If the environment stays good, stock prices will keep rising.
We can illustrate this point in a number of ways. Since the end of October, the S&P 500 is up 24%. We looked at every four-month period since 1990, where stocks rose at least 20%. We then looked at the average return the following year.
For example, if you bought every time the market rose 20%, what would your average return be the next year? The answer is 19.8%.
Note: that return is better than the overall average return of 10.8%. I.e., historically, you would have been better off buying after a big rally than all other periods.
We can also look at returns by the starting P/E ratio. Is there a consistent advantage to buying when the market is cheap (i.e., low P/E) vs. expensive (high P/E)?
The answer: not really.
Source: Bloomberg
On this chart, the horizontal axis is the P/E ratio at the start of a period, and the vertical axis is the return the following year.
What we see is no real pattern. Positive and negative returns scatter at various P/E ratios. Valuation does not predict future returns.
Historically, the stock market tends to keep going up as long as earnings growth is strong. It tends only to decline when earnings growth is weak. Going back to 1990, what was the average S&P 500 return in years where earnings growth was positive? 15.6%. If profits decline? 0.4%.
In conclusion, there’s no reason to believe today’s market is a bubble. In fact, stocks are being driven by what is a very positive earnings environment. If these positive conditions continue, history suggests stock prices will keep rising from here.
