Here’s When the Stock Bubble May Finally Burst

Dear Rich Lifer,

You’ve probably heard this classic stock market investor adage: “sell in May and go away.” 

In a typical year, it’s amazingly good advice…

But this year it looks like you can throw that playbook out the window. 

The S&P 500 increased 0.2% in May. In April, it traded at a cyclically adjusted price-to-earnings ratio of 37, a level not seen since the dot-com bubble of 1998. 

There seems to be no end in sight to this bull market.

Continually rising markets, soaring home prices and volatile cryptocurrencies have many investors worried that we are in another market bubble. 

Today you’ll hear what the experts say about the potential for the bubble to burst…

And you’ll find out which types of stocks you’ll want to keep your eye on until that happens.

Are We Even in a Bubble?  

Stefan Hofrichter, head of global economics and strategy at German fund management giant Allianz Global Investors, recently put together a list of 10 criteria for bubbles. Each indicator is rated for how concerned investors should be.

According to Mr. Hofrichter, the six criteria with the most cause for concern are: Overvaluations of multiple asset classes, high hopes for a “new era,”  ultra-easy monetary policy, financial-sector deregulation, a boom in innovative financial instruments, and overtrading and exponential price moves.

The four indicators with more mild cause for concern are: Historically high valuations, rising leverage, an influx of foreign money, and a rise in serious fraud. 

He commented, “As we have seen, most — but not all — of the criteria required for bubbles are waving red flags, and there are many similarities between the current period and the tech bubble of the late 1990s.” 

In particular, Mr. Hofrichter is not pleased with the current state of the stock market… 

Stock Market Bubble Indicators 

Current stock valuations are a significant cause for concern for Mr. Hofrichter. As we mentioned above, in April, the S&P 500 was trading at a price-earnings ratio of 37, a number not seen since the dot-com bubble. 

According to Mr. Hofrichter, when price-to-earnings ratios are historically high, it usually means poor returns in the future. 

Investor psychology also leads him to believe stocks are currently in a bubble. Mr. Hofrichter points out that there is an overwhelmingly high level of optimism about the degree of economic growth in the years ahead. 

Many tech firms have released bullish financial expectations for the next three to five years, pumping investors full of confidence in the future of the markets. He argues that economic growth won’t overperform after 2021, and central bank easing will be necessary for that to happen.

Mr. Hofrichter commented:

All financial bubbles in history took place against the backdrop of “easy” financing conditions provided by central banks. In that respect, this bubble indicator is clearly present today. Central banks have not only cut rates close to zero — or even lower — but they have flooded the system with levels of liquidity that are unprecedented in peacetime.

When Will the Bubble Burst? 

Although no one can be absolutely certain when a bubble will burst, Mr. Hofrichter estimates we can expect a pop in 2022, when many experts expect the Fed to start tightening financial conditions. 

He remarked, “History has shown that bubbles only burst once central banks start to hike rates or take other steps to rein in their ‘easy money’ policies.” 

This type of easing definitely won’t happen this year, as the Fed has indicated that its next rate increase likely won’t occur till 2024. However, Mr. Hofrichter does speculate that the Fed “will likely start to wind down (or ‘taper’) its bond purchases much earlier, possibly in 2022.”

So does this mean it’s time to sell?

Hold on to Value Stocks

Although Mr. Hofrichter is cautioning investors to keep their eyes open for bubble-bursting conditions, he doesn’t seem to be signaling it’s time to sell your stocks. 

Instead, he assumes stocks will continue to rise this year and recommends focusing your investment efforts on value stocks. 

Mr. Hofrichter advises: 

We think there is a reasonable chance that U.S. equities will continue bubbling up further. As a result, we stay nervously ‘risk on’ for now, gravitating towards risk assets. And we have a bias for value stocks, which are trading at a multidecade discount to growth stocks.

Value stocks have recently taken center stage, as growth stocks and cryptocurrencies experience volatile price jumps. Value stocks are beating growth stocks by the widest margins in two decades!

Value stocks tend to be larger, more well-established companies that are trading below the price that analysts feel the stock is worth. Meb Faber, chief investment officer of Cambria Investment Management LP, comments, “The beginning of this reopening trade has been a bounce for value stocks and smaller-cap names.”

This marks a huge shift from the market trends we saw last year when the pandemic slowed economic activity and investors flooded into shares of tech-heavy growth stocks. 

The Wall Street Journal reports, “Banks from UBS to Wells Fargo expect that the U.S. economy will continue accelerating, with many analysts saying cheap stocks that tend to rise during periods of growth are poised to benefit.” 

Value Stocks to Keep an Eye On 

If the banks and experts are correct, it looks like the perfect time to add some value stocks to your portfolio. 

Two EFTs to consider are the InfraCap MLP ETF and the Cambria Shareholder Yield ETF. 

Both of them have been on monster rallies but could have a lot more room to run. 

The InfraCap MLP ETF is an energy-focused fund that has risen 48% this year (due to the recovery of oil prices) and includes holdings like Energy Transfer LP, which is up 62% since December.

The Cambria Shareholder Yield ETF, which focuses on companies that return the most cash to its shareholders, has sky-rocketed 48% this year! 

This high-performing ETF includes funds like Rent-A-Center Inc. and Toll Brothers Inc., which have both gained more than 50%. 

The Avantis U.S. Small Cap Value ETF has also soared 36%, boosted by an 82% gain from Goodyear Tire & Rubber Co. and a climb of 72% from aluminum maker Alcoa Corp. 

As we move into the summer, keep your eyes on the bubble criteria. Hopefully, this expert advice will help you and your portfolio to continue to thrive.

To a Richer Life,

The Rich Life Roadmap Team 

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