Every sharp drop in the stock market revives the same question: is this another bubble? When prices fall quickly, the fear and anxiety many investors felt in 2000-2001 and again in 2008 come rushing back. You probably recall that the former was the “tech” bubble and the latter was coined the “housing” bubble. It is reasonable to ask whether another one could be forming, and how you would know.
What a Bubble Actually Is
A bubble forms when prices rise well beyond what the underlying economy and company earnings can reasonably support, usually because demand for an asset far outstrips anything that justifies it. Bubbles are easy to name after the fact and much harder to recognize while you are inside one.
A Lesson From the Years After 2008
By the end of the housing bubble, the broad market indices had been cut in half from their highs. The mortgage derivative and related products industries had collapsed and taken much of the economy and many jobs with them. Calling that a difficult time is a great understatement.
In an effort to support the economy and promote spending, the Federal Reserve undertook some unorthodox policies to hold interest rates low for years. One result was very low interest on treasury bonds, bank savings and similar accounts. Simply stated, there was almost nowhere to earn interest. So where would the multi-billion dollar pensions, trust accounts and mutual funds put money to at least earn dividends? That’s right, the stock market.
That sustained demand helped push market values up sharply in the years following the 2009 lows, during a period when most folks agreed the economy itself was not that strong. The lesson is a lasting one: when prices are driven more by where money has to go than by the health of the economy, some added caution is warranted.
Questions Worth Asking
- What does the long-term chart look like? Locate a chart of the US stock market that covers at least 30 years and compare the most recent stretch with any other time frame.
- Does the economy support the prices? Superimpose the true state of the economy on that same period. Has it grown at anything like the pace of market values?
- What is driving demand? Are investors buying because of business results, or because they feel they have nowhere else to go?
- How would a decline affect you? A drop that is uncomfortable at 35 can be far more serious a few years from retirement.
What This Means for Your Plan
No one can reliably predict when a market will fall or how far. What you can control is how prepared you are: a diversified portfolio, a level of risk that fits your time horizon, enough set aside for near-term needs, and a plan that keeps you from making decisions out of fear. If you are unsure whether your portfolio reflects the level of risk you are comfortable with, that is a conversation worth having before the next downturn rather than during it.
Toomey Investment Management a boutique wealth planning firm partnering with mid to high net worth individuals, families and businesses.