Year to date, the U.S. stock market, as measured by the S&P 500 Index, has returned about 10%, or an average year’s worth of gains in just over three months.
After every first-quarter rally, two categories of market observers tend to dominate the headlines: those who think stocks can continue to rise and those who warn that a bubble could be about to burst.
The latest rumors emanating from the latter camp have highlighted that stocks appear overvalued by the standards of none other than Warren Buffett. The Buffett Indicator compares the total market capitalization (stock price times shares outstanding) of all U.S. stocks with the quarterly output of the U.S. economy.
Things are in normal territory if the total value of the Wilshire 5000 index (which measures the overall market) is roughly comparable to the latest quarterly GDP estimate. If stocks represent around 70% of GDP, they are said to be undervalued. Stocks trading at around twice the size of the economy are seen as a major red flag.
Lately, the ratio has been around 190%, the highest mark in two years. In calendar year 2022, the last time stocks traded in this territory, the S&P 500 fell 18%.
So, is it time to prepare for impact? Not yet, says Liz Young, head of investment strategy at SoFi.
“If we compare a bubble to the late 90s and early 2000s, no, it’s not a bubble,” she says. “We’re in extended valuations, but we’re not outrageous, we’re not out of the ordinary.”
A “comforting” situation for stocks
Stay in the markets long enough and eventually you’ll see a bubble burst. This occurs when investors drive up the price of an asset to a point where valuations are no longer tied to historical norms and underlying fundamentals. When everyone realizes that they have got the upper hand on their skis, they start taking profits, prices fall, panic sets in and the asset quickly loses value.
Buffett’s favorite indicator is a flashing light for investors that stocks are in shaky territory by historical standards. But look at what’s driving the stocks and you’ll see that the current trend isn’t just a product of investor enthusiasm.
“The equity market rally we’ve seen so far has been fueled by earnings growth,” says Gargi Chaudhuri, chief investment and portfolio strategist for the Americas at BlackRock. “If this profit growth had not occurred, I might have been more willing to recognize the concept of a bubble.”
In short, stocks are doing well because the underlying companies – especially large, high-quality technology companies – are growing their profits.
“The most profitable names are doing very well. They are not speculative,” says Chaudhuri. “The fact that earnings growth continues to fuel returns is quite reassuring to me and should be to investors as well.”
Expect bumps
In many ways, the economic picture is also rosy.
“GDP growth remains strong, consumers continue to spend and profit growth is healthy and above expectations,” Young said. “The labor market has remained strong and inflation may have plateaued, but has not yet fully recovered. I think that’s the fundamental case for an increase.”
Still, she sees cracks in the economic façade. Although the above factors indicate the economy is in the middle of a bull cycle, Young says other indicators make it seem like the end is near.
The longest inversion of the yield curve and the marked rise in gold prices, for example, seem to indicate that certain pockets of investors are losing confidence in the economy.
The Fed is taking a delicate step in planning to cut interest rates this year without reigniting inflation concerns, Young says.
“Go back to any recession or economic downturn, and you’ll find headlines about the Fed achieving a soft landing,” she says.
Chaudhuri’s stock outlook for the rest of the year is more bullish, but she says investors shouldn’t expect positive performance over the next nine months.
“We’ve seen several weeks of incredible performance. Can we have moments and periods in the stock markets where we see a pullback? Absolutely,” she says. “By no means am I trying to say it gets higher and higher from here.”
Still, Chaudhuri says diversified stock portfolios will continue to benefit from growth in corporate profits and U.S. economic output. While interest rates are expected to remain relatively high, investors would do well to focus on highly profitable companies with low debt, she adds.
“The names that are doing well are the ones that are the most profitable and highest quality companies.”
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