Stock Market Bubble?

February 25, 2021

DWM’s year-end market commentary a few weeks ago talked about U.S. equity valuations being quite high.  Since then, we have witnessed the huge ups and downs of GameStop, a struggling video game retailer, whose shares were driven up 1700% by memes on social media and then quickly came back down.  IPOs have been exceptionally hot. Some folks are wondering if the markets have become the Wild West and we are in a stock market bubble, like the Roaring 20s or the 2000 bubble bust.

Earlier this week, Ray Dalio published an essay entitled “Stock Market Bubble?”  Our regular readers know Ray Dalio.  In 1975, he founded Bridgewater, one of the most successful hedge funds in the world. He has spent a lifetime studying investments, particularly historical patterns.  In 2007, Bridgewater suggested a global financial crisis was likely.  In 2011 he published “Principles” outlining his philosophy of investment and corporate management based on a “lifetime of observation, analysis and practical application.”  Here is a summary of Ray Dalio’s take on the current situation.  Please understand that Mr. Dalio’s analysis primarily focuses on large cap U.S. stocks, which is currently the equity style with the highest valuations- more than mid and small cap, emerging markets and international stocks.

Mr. Dalio defines a bubble as “an unsustainably high price” and analyzes it using measures (or gauges) going back as far as 1910.  In short, Mr. Dalio feels the aggregate bubble gauge for U.S. large cap stocks today is at about the 77th percentile-with the bubbles at 2000 and 1929 at 100 percent. Here are his six factors he’s been using for 50 years and his comments.

  • How high are prices relative to traditional measures? “Somewhat frothy.” Gauge is around the 82nd
  • Are prices discounting unsustainable conditions? “No Bubble.” This measure calculates the earnings growth rate that is required to produce equity returns in excess of bond returns. The current indicator is around the 77 percentile for the aggregate large cap market. While stock prices may be high in relation to absolute returns they are “not extremely high in relation to their bond market competitors.”
  • How many new buyers (i.e. those who weren’t previously in the market) have entered the market? “Frothy.”A rush of new entrants attracted by raising prices is often indicative of a bubble. They are typically entering the market because “it is hot and they are unsophisticated.” This was the case in both the 1929 and 2000 equity bubbles. This gauge has reached the 95th percentile recently due to the “flood of new retail investors into the most popular stocks, which have become individual “stock bubbles.”
  • How broadly bullish is sentiment? “Frothy.” According to Mr. Dalio, the more bullish the sentiment, the greater percentage of people who have already invested, so the less likely they will invest more. This indicator is at the 85th percentile and is again concentrated in the “bubble stocks” rather than most stocks. In addition, Initial Public Offerings (“IPOs”) have been exceptionally hot –hottest since the 2000 bubble.  “The current IPO pace has been brought about by the sentiment previously mentioned, as well as the SPAC boom, as these blank check acquisition companies have lower regulatory hurdles and greater flexibility to bring more speculative companies into the public markets.” However, sentiment from professional equity managers has moderated and “corporate engineering”, like buybacks and M&A, remains mediocre, as they are still working through the impact of the pandemic.
  • Are purchases being financed by high leverage? “Somewhat Frothy.” Leveraged purchases result in more pressure to sell in downturns. Dalio’s leverage gauge is in the 80th percentile. However, the highest leverage is in the retail sector using options for the “bubble stocks” while there is much less leverage in “non-bubble stocks.”
  • To what extent have buyers made exceptionally standard forward purchases? “No Bubble.”  This gauge measures whether business, and perhaps governments to a lesser degree, are expanding- buying equipment, investing in factories and buildings, adding infrastructure.  Historically, excess forward purchases may be the result of “overly optimistic expectations.”  This gauge is the weakest of the six measures at the 20th Today aggregate corporate capital spending has generally fallen in line with the huge reduction in demand caused by COVID. While certain digital economy players have managed to maintain their levels of investment, most businesses have not.


Below is a graph showing the aggregate gauge level over the last 110 years:


In conclusion, Mr. Dalio finds that “US stocks aren’t dangerously high- but 50 of the 1,000 biggest companies are in “extreme bubbles.” So, what do we do with this information?  First, we need to reiterate that Mr. Dalio’s measurements have been based on large cap stocks and that the overall values include the impact of the “bubble stocks.”  Second, the news loves to focus on extremes- big winners and big losers- whereas the broad market and areas not in so-called “bubbles” gets less coverage.

Diversification is a key.  Yes, the large cap stocks have done well in the last 10 years, but do you recall that during the previous decade, 2000-2009, the S&P 500 index was negative? In 2020, during the height of the pandemic, money flowed to the dozen or so strongest and largest companies.  Starting in September 2020, through 4Q20 and now into 2021, rotation came to the markets; bringing some normalcy with them in terms of relative valuation.  The S&P 500 has been positive during this time, but all other asset styles, including mid and small cap, emerging markets and international have outpaced the large caps.  You need appropriate exposure to all asset styles within the equity asset class.

Eliminating or minimizing the exposure to the bubble stocks is extremely important.  GameStop shows us that prices can go up almost overnight and come back down as quickly. Investors would be prudent to minimize their company-specific risk, e.g. keeping any of these “bubble stocks” to less than 5% of your portfolio and the aggregate of the “bubble stocks” to less than 15%.

At DWM, our client portfolios are not designed to hit home runs or strike out.  Solid singles and doubles is our goal for our clients. We do that by purposely NOT using individual stocks which lowers company-specific risk instead utilizing diversified low-cost mutual funds and ETFs.

We agree with Ray Dalio that there are certainly areas in the stock market that are overvalued and may be in “bubble” territory. However, we think that pertains only to certain pockets and that the broader market is in relatively better shape. Mid cap, small cap, international, and emerging markets all look “cheap” relative to Ray’s large cap focus.

Furthermore, when investing, one needs to think about all the asset classes, including equities, fixed income, alternatives, and cash. Frankly, equities should be the asset class of choice in the near term.  Why? It is highly likely that the economy is about to boom.  With Covid in retreat, places will open up. There’s pent up demand for many things, but particularly for things like leisure, restaurants, concert, travel, etc.  Interest rates going up means bond prices going down => so headwinds on fixed income. Further, you can bet that a lot of those $1400 stimulus checks or whatever amount they are will find their way into the stock market.

In conclusion, one never wants to time the market(s). The key is to stay properly diversified and in-line with your long term asset allocation target and rebalancing – taking advantage of short term mispricings -  when divergence occurs.



Detterbeck Wealth Management is a fee-only financial planning / wealth management company with offices located in Palatine, IL (Chicago area) and Charleston, SC areas serving clients locally and across the country. To contact us about setting up an appointment, please see our contact us page