Should you be worried about a stock market bubble?

The future well being of citizens today depends more on the stock market than ever before in history. This is largely due to a shift in the 1980s away from traditional “defined benefit” retirement pension plans in favor of individual “deferred savings” plans like the 401(k).

This shift – unintended if you’ve never heard the story – opened the door for tens of millions of people to become stock investors.

Individuals now rely on stocks for the promise of future prosperity and as a means of assuring financial security in their senior years.

Coinciding with the shift toward stock investing has been a demographic shift in our country.

  • Roughly 8,000 to 10,000 Baby Boomers reach retirement age every day.
  • By 2030, one in every five Americans will be over the age of 65.
  • This change represents an increase over the current senior population of 66%.

The original purpose of the stock market was to serve as a mechanism for businesses raise capital through the exchange of “shares” of ownership in a company.

Whether the market will be suited to serve in its new role of funding consumable income for a large segment of the future population remains to seen.

One factor impacting this question is the recurrence of stock market bubbles.

What is a stock market bubble?

Stock market bubbles occur as a result of cultural, political, and economic trends. They represent a flight from reality that is neither rational nor easily predictable.

A key question when thinking about stock market bubbles is, do stocks at any given time reflect a reasonable representation of their underlying values?

In essence, are stocks worth the prices for which they are trading?

The most fundamental expression of the value of stocks is the “P/E” or price earnings ratio.

  • This ratio is simply the price of stock divided by the stock’s earnings.
  • If a stock sells for $50 per share and has earnings of $5 per share, its P/E “ratio” is, 10.
  • $50 share price / $5 earnings = P/E of 10.

Usually the earnings used to calculate P/E are based on what a company actually earned in the prior year. P/E ratios are also commonly calculated for collections of stocks as represented by indexes such as the Dow Jones Industrial Index.

Historically, the Dow has had an average P/E of about 15.

When former Federal Reserve Board Chairman Alan Greenspan made his famous remark about “irrational exuberance,” it was early in December of 1996. At the time, the Dow was trading around 6,700 with an average P/E of 25. However, it wasn’t until five or so years later in 2000/2002, that the bubble finally burst.

There have been at least five major bubbles in the last 116 years: 1901, 1929, 1966, 2000/2002, 2008/2009. Some point out that the time span between recent crashes has decreased.

Below is a chart from Nobel Prize winning economist Robert Shiller that shows real or “inflation corrected” prices versus earnings for U.S. Stocks from 1870 through modern times.

(For advanced students, see Dr. Shiller’s P/E chart reflecting “real” ten year trailing earnings.)

Robert Shiller S&P 500 S&P Composite Stock Price Chart

You can see from the chart above that bubbles generally occur in relationship to the spread between the prices of stocks and their earnings.

When the next bubble will occur is anyone’s guess.

The older people become, the less time they have to recover from the negative effects of market turbulence like bubbles. To protect themselves, individuals should become more aware of the risks associated with stock investing, seek help from a qualified advisor, and plan accordingly.

Click to learn how to create reliable income for your retirement regardless of whether the market goes up or down. 

What are your thoughts?

  • Does it surprise you to learn that the senior population is increasing by such a large extent?
  • Have you ever thought about or looked at P/E ratios before?
  • Do you think the stock market will be able to provide a reliable means of income security for our growing senior population?
  • Have you ever wondered how you will derive income from your nest egg to pay bills when you retire?