Have you noticed that equity investors can’t have nice things? As miserable as we are when stocks are going down, we’re even unhappier when they’re going up.
There’s an explanation for this psychological phenomenon: loss aversion. Humans have all sorts of cognitive biases, and one of the more perverse ones is that we experience far more pain from losing money than we experience pleasure from winning the same amount. That’s why when markets are rising, stocks are said to be climbing a wall of worry. The higher stocks climb, the more investor anxiety mounts.
That’s loss aversion at work. Cut to today, with markets at record highs and valuations stretched, it’s only natural for investors to question if stocks are in a bubble. Stocks never go up in a straight line, but that’s pretty much what the S&P 500 has done after bottoming out in late October last year.
“The S&P 500 is statistically expensive on 19 of the 20 metrics we track and is trading at its 95th percentile based on trailing P/E, based on data since 1900,” writes Savita Subramanian, head of U.S. equity strategy and U.S. quantitative strategy at BofA Global Research, in a note to clients.
Happily, valuation is not a timing tool, as strategists take pains to point out. Subramanian actually argues that the market isn’t quite as richly valued as it appears at first blush. Perhaps most important, bubbles are as much of a psychological phenomenon as a financial one.
Nicholas Colas, co-founder of DataTrek Research, started working full-time on Wall Street in 1986. He’s developed a three-point checklist for “spotting unhealthy, runaway markets.”
Here’s a thumbnail version:
The market for initial public offerings gets frothy.“After never averaging more than a 25 percent first-day pop, the IPOs of 1999 saw a mean day one gain of 71%,” Colas writes. “Moreover, there was an average of two IPOs/day that year (476 in total), a record back to at least 1980. Scarcity value doesn’t explain the first-day moves. Irrational exuberance does. U.S. equities peaked in March 2000.”
Colas notes that based on IPO activity, markets are still nowhere near bubble territory. There were just 54 IPOs in 2023, and they averaged a first-day gain of 12 percent, he says.
Hallmark mergers and acquisitions deals.“M&A activity is ultimately a function of CEO/board confidence. Just like retail investors chasing hot IPOs at a market peak, senior managers fall prey to the same overconfidence that the good times will last forever,” Colas writes.
Happily, M&A activity is only picking up now after a slow 2023, Colas says, “a good sign that equity markets are not yet in bubble territory.”
A double is a bubble. Colas has a simple rule of thumb to identify unsustainably high prices in a range of markets. Whenever the S&P 500 doubles in three years or less, stock prices decline shortly thereafter. The same is true for the Nasdaq Composite. “When prices double, you know speculation—not fundamentals—are driving those gains,” Colas says.
Even the Nasdaq Composite, which is the frothiest equity market right now, is up “only” 40 percent over the past year.
