Counseling clients about stock market bubbles is an indispensable part of a financial advisor’s job. It prepares clients for retirement and helps them sidestep pitfalls.
For years, the lesson for investing in stocks has been akin to a childhood game of blowing bubbles: Fill the loop at the end of the wand with liquid, blow the bubbles out and watch them fly. In other words, fill your portfolio with quality investments and stick with them, buy the dips and rely on stocks to go up in the long run.
But as of early 2021, it is getting more apparent that investors face the risk of losing wealth in the stock market and not making it back quickly. That, and a host of other factors, could ultimately leave investors with the feeling that the liquidity in their bottle of bubbles has run out.
Explaining Stock Market Bubbles to Clients
Clients could be forgiven for not remembering the last time they had to worry about stocks losing value or for being hesitant to make adjustments. After all, it has been a long, rarely interrupted bull market for stocks.
But what they don’t remember could hurt them. Clients who are in retirement or approaching it are in a unique, and possibly precarious, position. The last time the stock market ravaged portfolios for a sustained period of time, those clients were 12 years younger than they are now. And there is quite a difference between a 50-year-old investor in 2009 and a 62-year-old investor in 2021. For one thing, now they probably have a lot more money invested, and thus have more to lose. Furthermore, interest rates are near zero, limiting their ability to simply punt their stock exposure over to bonds and earn a solid return.
The conversation starts by helping clients understand that the stock market is, above all else, a cyclical beast. That is the case whether you are advising a long-term investor, a short-term trader or someone in between. Explain that stock prices move up and down in fits and starts, not in a straight line. Over time, they carve out patterns that tend to repeat, though those movements are not identical. Today’s investors are so inundated with breaking news about every little thing that it is easy to miss the “trading range” forest for the “secular cycle” trees.
There are several indicators that help advisors gauge where we are in a bull or bear cycle.
Taking an honest look at today’s market environment, you can point to the following signals that we are in a stock bubble:
— Valuations are near or at all-time highs.
— There is an implied “investor safety net” in the form of Federal Reserve policy and government stimulus.
— Investor sentiment is somewhere between thrilled and ecstatic.
Read on for what advisors should know.
Valuations Are Near or at All-Time Highs
One such indicator, the cyclically adjusted price-to-earnings (CAPE) ratio created by Yale professor Robert Shiller, currently stands at a level exceeded only during the other extreme stock bubble in our lifetimes: the dot-com bubble that popped in 2000.
It is not just earnings valuations that are extended. The S&P 500’s price-to-sales ratio is approaching a three-times rate. To put that in context, that’s double the heights reached prior to the financial crisis in 2007. And it’s about 50% higher than the roughly two-times rate it sold for at the height of the dot-com bubble. Are companies now that valuable compared to their revenue? It calls for caution.
There Is an Implied ‘Investor Safety Net’ Via Fed Policy and Government Stimulus
Recent stimulus and monetary policies have allowed the market to ignore a lot of nagging issues, including heavy corporate debt, the lack of new investment by businesses in favor of buying back stock and other behaviors that have persisted since the end of the global financial crisis.
Another glaring example of this is the continued suppression of short-term interest rates by the Federal Reserve. Rates of three-month Treasury bills had rarely been below 2% since the 1950s. But they sunk below 2% and have remained low since the start of 2008. This has helped some parts of the economy but has left a generation of baby boomers, many of whom saved and invested well, with minimal return on cash investments. That has convinced some boomers to venture into the stock market with greater vigor than they may have anticipated.
And while the stock market has produced some solid returns, this style of investing could be a hard habit to break when the implied safety net of easy borrowing conditions reverses.
Only when the damage to equity portfolios is done will investors know the full extent of the risk they’ve been taking.
Investor Sentiment Is Somewhere Between Thrilled and Ecstatic
Though there are several quantitative indicators that point to over-the-top investor sentiment, the most telling could be anecdotal. Amid headlines about the “short squeeze,” special purpose acquisition companies that raise money to buy a not-yet-selected business and record-high margin debt, there is a palpable feeling of invincibility that has increasingly reared its head.
Stock investing has gone from functional to fashionable. And although broader investor participation is generally a good thing, history is riddled with periods like this that preceded a fall. When newbie investors come in with plenty of confidence and minimal fear, it tends to end badly for them.
This is where you come in. As an advisor, you have access to the tools and data to put stock cycles in perspective for your clients. You can balance their fear of missing out, known as FOMO, a natural feeling at this stage in the stock cycle, with evidence and a rationale for prioritizing their retirement goals over the latest get-rich-quick sound bite. Your clients will benefit from your ability and willingness to explain to them how to relate today’s events to what has happened before.
For the data-assisted part of this, you can present them with rolling returns that clearly show that not accounting for bursting bubbles can damage their investment returns over five-, 10- and even 15-year periods. When you do this, they’ll also see that we have just lived through very favorable times for investors. More importantly, you can use the illustration to emphasize that returns are cyclical.
The data may help you get their attention, but you will still need to put it in the context of today’s stock market environment. The so-called recency effect is compounded by outside influences that compete with your advice. Social media, bragging friends and stock-tip services are among the many forms of distraction.
Hype from unregulated entities and those who are not fiduciaries may plant dangerous seeds of doubt in investors’ minds. Clients can easily forget your unique role in their financial lives, so use the combination of your advice, education and evidence to drive your message home.
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How to Explain Stock Market Bubbles to Your Clients originally appeared on usnews.com