Investors debate signs of market bubble

A perspective from E*TRADE Securities 01/22/21

Despite the global pandemic, stock market bulls have charged ahead, driving the S&P 500® to 33 record closes when 2020 was said and done.1 But are some investors now wondering if the record-breaking market rebound was too much, too fast?

The latest E*TRADE StreetWise survey, a quarterly tracking study of experienced investors, revealed most investors (66%) believe the market is in bubble territory, and another 25% think it’s approaching one.2

If we are in a bubble, is it about to burst? Or is this just another example of the stock market “climbing a wall of worry”? Let’s look at both sides of the debate.

Fueling the bubble outlook

The apparent uncertainty revealed in the survey is highlighted by the fact that not only do two out of three investors say we’re fully or somewhat in a market bubble, three in five expect volatility to pick up this quarter. A few factors may be fueling the unease.

First, stocks are relatively expensive. Optimism for the future has driven the major US benchmarks to record highs, despite the ongoing pandemic and the prospect of a long road to full economic recovery. Valuation metrics such as the forward price-earnings (P/E) ratio of the S&P 500 are well above both the five- and 10-year averages.3

Second, longer-term interest rates have risen. The yield on the bellwether 10-year Treasury note has moved markedly higher over the past few weeks. While a steady rise in rates is typically seen as a positive sign for economic prospects, it can create headwinds for stocks—especially if it occurs quickly—since higher rates can increase borrowing costs, cutting into corporate earnings. 

Source: FactSet


Also, there’s the possibility that the market has already priced in the majority of the good news. While investors may see unprecedented fiscal stimulus, the Fed’s easy monetary policy, the vaccine rollout, and relatively healthy earnings as positives, it begs the question of where the market will find its next catalyst. 

The other side of the debate

At the same time, bullish sentiment among investors hasn’t necessarily waned. More than half of surveyed investors (57%) were bullish—up five percentage points since Q4 2020. 

Consider the other side of the bubble debate. Some analysts point out the rally has broadened to include some areas of the market that were hit hardest during the virus-induced downturn last February–March, producing new market leadership toward the end of last year. Gains aren’t solely concentrated in a few pandemic-era winners: Cyclical sectors tied to economic growth, like energy, financials, and materials, have outperformed the broad market over the past several months.

Source: FactSet, as of 1/20/21


In terms of the effect of rising interest rates on the stock market, the reason for the increase matters. If they’re rising because investors are feeling more confident about the economy, the effect is generally muted. Rates are, from a historical perspective, still very low, and some analysts expect longer-term rates will move higher as the recovery finds its footing. 

It’s also important to consider how the events of the past year have changed the investing landscape. Post-pandemic economies and markets may create new opportunities and risks that require a different playbook. Our colleagues at Morgan Stanley have a library of insight and research on this front. So, while the good news may be priced in here and there, it doesn’t mean new opportunities aren’t on the horizon. 

Investing considerations

Whichever side of the bubble debate investors find themselves on, here are a few things to consider:

  • Take a more selective approach: Over the past decade, investing in a fund that tracks a major benchmark like the S&P 500 or Nasdaq Composite has produced great returns. But the broad-based indexes may be hard pressed to repeat performances like last year’s. Investors may be turning to focus on the fundamentals of individual companies and sectors.
  • Balance leaders with laggards: For investors hesitant to stray too far from the comfort of large-cap growth names, adding exposure to other areas of the market may help balance risk and returns. For example, small caps to balance large caps, value-oriented strategies to balance growth, and international stocks to balance US equities. This is the hallmark of sound diversification.
  • Explore the new cycle playbook: There are a few dynamics that some market watchers, including the investment team at Morgan Stanley, expect to define the next business cycle. Assets that are positively correlated to economic growth, higher interest rates, and inflation may be positioned favorably for these shifts. That may include smaller-cap companies, financials, materials, consumer discretionary/services, and industrials, among others.

Keep in mind, volatility may be par for the course as we continue to recover. Kicking off the new year, it’s good practice to reassess financial goals and risk tolerance, and realign portfolios accordingly.

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  1. USA Today, “S&P 500 closes out 2020 at record high after a quiet trading day but a year of wild swings,” 12/31/20, https://www.usatoday.com/story/money/2020/12/31/dow-jones-stocks-were-flat-early-trading-after-year-sharp-swings/4099199001/
  2. This wave of the survey was conducted from January 1 to January 7 of 2021 among an online US sample of 904 self-directed active investors who manage at least $10,000 in an online brokerage account. The survey has a margin of error of ±3.20 percent at the 95 percent confidence level. It was fielded and administered by Dynata. The panel is broken into thirds of active (trade more than once a week), swing (trade less than once a week but more than once a month), and passive (trade less than once a month). The panel is 60% male and 40% female, with an even distribution across online brokerages, geographic regions, and age bands. Access the full press release and referenced data here.
  3. FactSet Earnings Insight, 1/15/21, https://www.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_011521A.pdf

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