Fears of a stock market bubble have circulated for years. We’ve even had two pretty severe crashes, with the Dow Jones Industrial Average falling 20% from October to December 2018 and falling 35% in early 2020 as a result of COVID lockdowns. While stock markets have since recovered, there’s every indication that those “minor” corrections aren’t even close to what we’ll see when the real correction occurs.
Stock markets are prone to corrections as the business cycle runs its course. They’re often a lagging indicator, as they don’t begin to really fall until recessions or financial crises are well underway. In the 2008 crisis, for instance, the recession officially began in December 2007, but stock markets peaked in October 2007 and didn’t really begin to show major signs of distress until September 2008.
Diagnosing bubbles is often done in hindsight, which is of little comfort for investors who stand to lose tens or hundreds of thousands of dollars in a stock market crash. But if you’re able to spot the warning signs before a crash, you might be able to spare yourself some of the heartache and loss that you otherwise might subject yourself to.
Stock markets today are flashing warning signs that they’re overvalued and overdue for a correction. And the stock market bubble today could be the worst ever, making both the dotcom bubble and the 2008 crisis look like child’s play. Here are three reasons this current stock market could be the mother of all stock market bubbles.
1. Buffett Indicator at an All-Time High
The Buffet indicator is named after legendary investor Warren Buffett, who called the statistical relationship between stock market prices and overall economic output the “best single measure of where valuations stand at any given moment.” The Buffett indicator is simply the ratio of stock market capitalization to gross domestic product (GDP). And today the Buffett indicator is higher than it ever has been.
The last time the Buffett indicator was this high was right before the dotcom bubble crashed. And the size of the current bubble even surpasses the excesses of that era. The Buffett indicator was 71% higher than the trend line before the dotcom bubble burst, and it’s 88% higher than the trend line today. How much longer will stock markets continue to climb before the correction finally occurs?
2. Stocks Are Overvalued by Most Metrics
It isn’t just the Buffett indicator that’s demonstrating how overvalued stocks are. By most common metrics, stocks are trading for prices far higher than they should be.
The price to earnings (P/E) ratio is probably the most common ratio used by investors. By that measure, the S&P 500 isn’t the most overvalued it has been, but it’s rapidly approaching levels nearly equal to those seen during the dotcom bubble.
The price to sales (P/S) ratio is less commonly used or discussed, but it’s another useful metric. Data doesn’t go back as far as it does for the P/E ratio, but what we can see is that the P/S ratio for the S&P 500 is higher than it ever has been, more than 50% higher than it was during either the dotcom bubble or before the 2008 financial crisis. That’s another indicator that stock prices are way out of line with where they should be trading based on companies’ actual financial performance.
3. Unease in Bond Markets
Bond yields on longer-dated Treasury bonds have risen dramatically this year, with the benchmark 10-year bond rising 60 basis points. All of this is without the Fed having made any official changes to monetary policy.
Some analysts believe that this is just due to markets pricing in inflation, which has begun to rise, especially for food and energy. But there’s growing fear that, if bond yields continue to rise, the Fed may lose control of bond markets.
The confidence that markets have in the Fed is that the central bank will continue to keep monetary policy loose in order to stimulate economic activity, but also that it will be able to keep inflation from rising out of control. If markets lose that confidence, and fear either that the Fed will start hiking rates, or that it will allow inflation to rise out of control, then panic could ensue. Stock markets may bear the brunt of that when stock prices collapse, but the precursor to that could be in bond markets if bond yields continue to rise.
Wealth Protection Is Key
If stock markets really are on the verge of a crash, then the key for investors will be to maintain as much wealth as possible. During the dotcom bubble, some of the highest-flying stocks fell to zero as their companies disappeared. During the 2008 crisis, stock markets lost over 50% of their value. And the next crash could very well be larger than either of those two.
There are still innumerable investors out there convinced that stock markets are going to keep climbing. Some of them believe that the economy is going to rebound from COVID lockdowns and return to full strength. Others believe that the massive amounts of stimulus entering the economy will keep stock markets juiced for a long while. But the danger is that this stimulus could boost inflation to such an extent that we see a return to the stagflationary environment of the 1970s, with high inflation and weak stock markets.
Investors haven’t seen an investment environment like that in over 40 years, and for many investors that would be an unexpected shock. But historical experience can help them.
Investors in the 1970s were able to benefit from gold’s explosive growth in the aftermath of the gold window being closed in 1971. From August 1971 to the end of the 1970s, gold increased over 10-fold in value, or nearly 1,000%. During that same period, the S&P 500 only grew 9.3%.
Gold’s performance during the 2008 crisis wasn’t nearly as dramatic, but it was significantly greater than stock markets, with gold increasing 25% in value while stock markets decreased over 50%. And once the recession was over, gold continued to make gains for years.
If that trend reasserts itself after the next financial crisis, and there’s no reason to believe that it won’t, then gold could once again see massive gains while stock markets falter. So if you’re worried about the performance of stock markets and want to protect your assets, maybe it’s time to start thinking about buying gold. Give Goldco a call today and let our experts help you learn how to protect your investments with gold.