Third Quarter 2017 Letter to Clients

“Is the stock market in another bubble?”

Of all the questions we field from clients, prospects, friends and family – the question of whether we are in a bubble leads the way by far.

There are two reasons why this question comes up so frequently these days. First, we are in the midst of a long-running bull market, one that has seen the major market indexes push through record highs time and time again. When stock indexes are as high as they’ve ever been, investors become uneasy, and thoughts of bubbles ensue. It’s not hard to understand this mindset; the psychic trauma that resulted from the 2008-09 bear market is still fresh in the minds of investors despite the fact that we are almost a decade removed from that event. No matter how much the market moves higher, many investors remain guarded, anxious about the possibility of another big downturn in stocks.

The second reason the bubble question lingers in the minds of investors is that the media is constantly raising the subject for its own self-interest. Talk of financial bubbles generates anxious clicks on web sites and viewers on television shows, and that generates ad revenue. Interestingly, you can find bubble-related articles literally every year going back to 2010 – when, we remind you, the Dow was hovering in the 10,000-range. Consider these headlines during that span (source:

  • “US stocks surge back towards bubble territory” (Business Insider, January 11, 2010)
  • “Why this stock market looks like the tech bubble of 2000 all over again” (Business Insider, May 3, 2011)
  • “Robert Shiller eyes another tech bubble” (Yahoo! Finance, March 27, 2012)
  • “Nobel prize winner warns of US stock market bubble” (CNBC, December 2, 2013)
  • “Time to worry about stock market bubbles” (New York Times, May 6, 2014)
  • “Fears grow over US stock market bubble” (Financial Times, September 13, 2015)
  • “Uh-oh. Is the stock market in a bubble again?” (CNN Money, June 23, 2016)
  • “Is the stock market a bubble?” (USA Today, August 9, 2017)

Clearly, there is less interest in the media about being right on the question of whether we are in a stock bubble than there is in creating anxiety about it. Nonetheless, it is worth examining the subject in more detail to see if there is merit to the current “bubble fear.”

In that regard, here are a few points to consider:

Stock prices are reasonable relative to fundamentals: While there is much hand-wringing about the stock market being at an all-time high, there is relatively little focus on the reason that stocks are at such levels: soaring corporate earnings and profits.

Since 2009, earnings by U.S. corporations have been on a steady upward climb, and that climb has accelerated significantly in the past two years. In fact, earnings-per-share for corporations around the world have spiked higher during that same time span:

Likewise, corporate profits for S&P 500 companies are in record territory: So, while stocks prices continue to trend higher, the underlying reason for the upward trend is based on fundamentals, not feverish speculation. And while that doesn’t mean the stock market won’t suddenly head into a downturn, it does discredit the idea that we are in a stock bubble.

Individual investors are not especially bullish: The American Association of Individual Investors (AAII) tracks the sentiment of its members on an ongoing basis to gauge how small investors feel about the market. As of October 4, only 35% of the AAII members categorized themselves as bullish, marking the 35th time this year that indicator has come in below its long-term average of 38% bullish.

In contrast, in early 2000 – right before the bursting of the dot-com bubble – more than 60% of AAII investors considered themselves bullish.

Stock bubbles don’t set in until bears throw in the towel: To continue the prior point, no stock market bubble ever came into being during a period of high pessimism in the market, or even rational caution. Bubbles are only possible when investors throw caution to the wind and load up on anything and everything that has to do with the flavor of the day, no matter what the asset price may be. This was certainly the case in 1999 with dot-com stocks, and again in 2007 with the housing market. (Remember when it seemed impossible for housing values to actually go down?)

This seems an appropriate time to review the ubiquitous “Cycle of Investor Emotions” to gain some perspective on where we are in the current market cycle:


Although this chart is hardly empirical, it is nonetheless accurate. Looking at the present market environment, it seems hard to characterize it as “euphoric” given the level of pessimism that still persists with investors. Ironically, it is that pessimism that should give long-term investors some measure of comfort that the current bull market may yet have a ways to go.

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Lost among the avalanche of football scores that were crossing the wire this past weekend was an interesting bit of non-sports news. Richard Thaler, the famed behavioral economist and University of Chicago professor, was awarded the Nobel Prize in Economic Sciences for 2017.

Dr. Thaler joins an impressive list of Nobel Laureates at the University of Chicago – more than two dozen in all – who for the past half-century have shaped the school’s economic sciences department into one of the world’s foremost capital markets thinktanks.

Dr. Thaler won the award for his extensive research into the role that human behavior – especially emotion – plays in investment decisions. For most of the 20th century, investing was viewed purely from an analytical perspective; Dr. Thaler and his contemporaries opened the door to examining the role that emotional decision-making plays in impacting investor returns.

Of particular interest in Dr. Thaler’s research was the finding that investors experience losses much more acutely than they do gains. In other words, it’s more painful for most investors to lose a dollar than it is gratifying to gain one. This reality helps explain why investors often end up locking in losses at exactly the time they most want to avoid them. The fear of watching their portfolio decline even more outweighs the more prudent desire to stay invested and wait for a downturn to run its course.

At Capital Directions, we have always viewed the most important role of an investment advisor as that of “behavioral counselor,” because it is in the moments of market extremes – especially on the down side – that emotions become overwhelming for investors and long-term planning becomes vulnerable to short-term, panicky decision making. In our view, nothing is more important to protecting the wealth of our clients than helping to be the buffer between our clients’ money and their emotions.