Afraid of a Market Bubble? Don’t Buy Bubble Stocks

Jeremy Grantham is a legend. He says Wall Street is in a bubble bigger than the one that popped in the dot-com era.

That’s the headline people are spreading to make you nervous enough to sell your stocks. It worked well before the bargain hunters swooped back in.

The S&P 500 dropped almost 4% from its peak. Now, the market is back on its record-breaking trajectory, and the valuations people were fretting about as “unprecedented” are evidently less of a problem.

What changed? Earnings are solid, but the long-term picture has gotten a little cloudier as company after company provides good 2022 guidance without promising anything truly spectacular.

But we can’t blame the fundamentals when that slightly weaker outlook supports the highest stock prices in history. And that tells me the market isn’t really paying attention to the fundamentals at all.

Just look at Jeremy Grantham. While he sees bubble conditions in the market, he admits he can’t predict how far the bubble will inflate before it pops.

Timing is critical. And as long as the mood keeps swinging between extremes, the market as a whole can keep climbing to unprecedented levels, giving the fundamentals time to catch up.

Not All Stocks Are in the Nosebleed Zone

As I write, the S&P 500 is back in record territory and commands a lofty 21.3X earnings multiple. Everything we know about market history suggests these conditions won’t last forever.

After all, while we’re looking for earnings growth of 38% this year, 2022 is only five months away. At that point, the year-over-year comparisons get a lot tougher and growth might drop to 10%.

Even though 10% growth would be attractive under normal conditions, it’s hard to justify paying a 21X multiple to buy into that overall narrative.

Let’s simplify the logic even further. Corporate operations are good. But the market as a whole is priced for perfection and we’re unlikely to see anything better, at least in the next 12-18 months.

In that scenario, Wall Street is an over-inflated bubble waiting for the inevitable encounter with a sharp object to end the fantasy and bring investor expectations back to earth.

That’s the outcome Jeremy Grantham sees. But as I always say, “the market” is an illusion for those of us who buy and sell individual stocks.

If “the market” is overinflated and unsustainable, that’s only incidentally our concern. In my world, about 40% of the S&P 500 is already 10% or more below record territory and a full 10% of the index is technically back in the bear market zone.

We know these stocks have room to rally. They’ve done it in the recent past and in the post-pandemic world. Except in rare cases where something has broken within a specific company, nothing fundamental has changed.

The only thing that has taken these stocks down is investor psychology. Traders lost their nerve. And while it’s harder to restore confidence than it is to break it down, sentiment remains a state of mind.

We’ve already seen sentiment swing a full 180 degrees in the last two weeks. When earnings season started, the numbers were good and stocks sold off anyway.

Now, the numbers are good and stocks are rebounding, breaking records in the process. That’s a sentiment story, not a fundamental story.

Anyone who tries to explain that story with fundamentals is either confused or trying to confuse you. Remember, you’re the only person who can control your own psychology.

Your confidence is up to you. If you truly believe U.S. companies have peaked and the future will be worse than the past… don’t buy stocks. There are other asset classes that fit your confidence level.

I might be old-fashioned, but I believe U.S. companies can beat any obstacle in their way. They’ve beaten tax concerns, inflation, global competition and other factors, again and again.

In recent memory, they’ve beaten a global pandemic and total economic lockdown. We’ve done it before. We’ll do it again.

Growth And Value

And if you feel the same way I do, it isn’t a matter of worrying about the market as a whole. All we need to do is find stocks that are growing fast enough to justify their prices.

Sometimes, that means concentrating on growth. There are easily 1,400 stocks right now that are growing faster than the S&P 500 as a whole, and about half of them will continue that outperformance through next year.

This is where I focus my efforts in GameChangers. In general, these stocks are naturally more expensive relative to their earnings because they’re growing into that valuation at an accelerated rate.

You simply don’t need to wait as long for that multiple to shrink to a reasonable level. And as long as growth continues, the multiple can stay inflated while the stock price keeps climbing.

When it stops, it stops. I don’t see that happening until the Fed finally feels confident enough to let interest rates start climbing.

Maybe you just don’t like high valuations. That’s all right, too. My Value Authority remains open to the roughly 2,000 stocks that are cheap compared to the market as a whole.

Suddenly the world doesn’t look so bad. And with so many stocks either growing into their multiples or trading at low multiples, the “bubble” doesn’t look so bad either.