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What to do when bubble bursts

February 15, 2018

My previous blog suggested standing pat when there is a substantial drop in the stock market. Today I want to discuss what to do if we are in a bubble and note that there is always the danger of the bubble bursting.

When the bubble bursts, it could be too late, but we haven’t seen a bubble in the Dow Jones Industrial Average or S&P 500 since maybe October 1987 when the DJIA fell 508 points which was 22.6%. There was a rapid run up of 44% the previous year so it looked like there had to be a reality check. Coinciding with the 44% increase were a number of major economic and political disasters exacerbating the stock market climate. However, this recovered fully by early 1989. Also the economy appeared to be unaffected by the “crash.”

The Dot Com bubble burst in 2000 but the DJIA was relatively unaffected and the S&P 500 somewhat affected since many of the large NASDAQ companies were also in that index.

The 2008/2009 crash was not as much from a bubble as from the massive failure of a number of banks, brokerage firms and investment banks caused by the spurious mortgages that were granted. The low point of the DJIA was on Mar 9, 2009 at 6509. However, we recovered quite quickly from this.

There have been other bubble bursts and some huge drops such as the reaction to the terrible events of Sep 11, 2001, and but that recovered pretty quickly and then we had the Enron failure which actually had a greater effect on the market than the Sep 11 attacks, but these were not bubbles.

So, what do you do if there is a stock market bubble and how do you protect yourself from it bursting?

  • I define “bubble” as a huge run up in prices that are not founded in underlying substance, in particular projected sustainable profitable sales.
  • Occasionally certain stocks can have great run ups without the underlying profitable sales, but these are usually exceptions and special cases.
  • If stock investments are in a broad based diversified portfolio then the sudden and dramatic drop in some components should not cause havoc and great losses for the portfolio.
  • The problem arises when there is a bubble in an entire sector or major grouping, such as with the Dot-Com companies in late 1990s.

Now, let’s look at the markets today. The 2017 run up in the DJIA, S&P 500 and NASDAQ were from 20 to 27% [see the chart in the Jan 11, 2018 blog]. These are certainly high, but the underlying fundamentals were reasonable and were able to support the new index levels. I explained this in my Jan 16 blog, and that explanation did not indicate an unnecessary concern by me given the low interest rate and inflation environment. So what happened since Jan 16? Nothing much and to me, nothing alarming. The short term treasury rate went up about .4% to about 1.8% and the 10 year Treasury went up also about .4% to about 2.8%. The 10 year rate, in context, was not alarming. The T-Bill rate was somewhat alarming to the news media since that gave them something to talk about. It was also an indication that there might be inflation and every time there is a threat of inflation the stock market drops. This action contradicts what my father told me when I was a little boy about the stock market being a hedge against inflation. It is, for the long term, but for the short term, interest yields could approach or exceed the dividend yields with complete safety of principal. So, there is some liquidation of stocks in favor of T Bills or shorter term Treasuries (up to five years). That would pull stocks down.

You see, stocks compete with fixed income choices when bond yields rise making stocks less attractive. Rising rates also portend inflation which also means higher interest rates. However, over a long period, inflation will work its way into corporate earnings and that will push stocks prices higher, making my father’s belief right.

Getting back to the relative values, some of the trailing P/Es are pretty high, but the forward P/Es, not so far off traditional amounts. Dividends are also pretty reasonable for DJIA and S&P500, but low for the NASDAQ but keep in mind that this includes heavily weighted and high PE Alphabet, Google, Amazon, and Facebook that do not pay any dividends. Also these four are also heavily weighted in the S&P 500, but there are much more higher dividend paying stocks to bring up the yield there. None of those stocks are in the DJIA.

I am a CPA and financial planner and do not manage portfolios or offer specific investment advice, so did not do the exhaustive studies and analysis needed for such recommendations, but experience indicates that there is no bubble that is risking being burst. There will be events that cause momentary drops but I believe the long term strength of the market is strong. I do not see any reason at this time to change investment plans or your asset allocation.

This blog discussed bubbles and seemed to indicate my opinion that we are not in a bubble. I tried to explain how to recognize when we are approaching a bubble. There will be drops but these are expected in the journey to the future financial security we should all carve. I did not say what to do when the bubble bursts, because I do not think we are in a bubble. Let’s hope I never get to write that blog. Let’s also hope that you will never need to read it.

FYI, Wikipedia has a great list of stock market crashes and bear markets. Here is a link:
https://en.wikipedia.org/wiki/List_of_stock_market_crashes_and_bear_markets

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