Stocks look bubbly

Many market watchers, including me, are concerned about the recent run-up in the US stock market.

Can we realistically expect more of the same, or are we likely to see a correction? If so, how bad might it be?

A look at the most-recent five-year period compared to the history of five-year periods stretching back decades provides some perspective.

 

stocks

 

Outsized Returns

The S&P 500 has earned an annualized return of 15.28% over the past five years, through December 20, 2016.

This compares to an average 91-year return on the S&P of 10%. So the past 5 years are well above average.

It’s precisely this above average return that is causing concern that the U.S. stock market is overpriced, but, as you can see, there have been strings of above average 5-year periods that stretch for 20 years, so this concern might be unwarranted.

 

Warning Signals

So what makes this past five years different?

There appears to be a bigger pattern in stock prices that oscillates on a 20-year schedule – above average for 20 years, then below average.

If this pattern is currently repeating, in my view, we are in a 20-year down period that has been interrupted in the past five years.

The other thing that’s different this time in my opinion is the unprecedented run of ultra-low interest rates, thanks to various quantitative easing and bond-buying programs at global central banks.

Last, but not least, we could be repeating the “Fools Rally” of 1932-1936, when the market temporarily rebounded from the Great Depression, only to be slapped down again in the subsequent 5 years.

 

Bonds

The following graph shows the history of 5-year bond returns:

The Barclays Aggregate Bond Index has returned 2.74% over the past 5 years, which is below the 6% long-term average.

Yet here, in my opinion, expectations should be governed more by the current level of interest rates than by historical patterns.

With nominal interest rates near zero, and real rates below zero, I believe something is totally wrong.  

Will this balloon pop or gradually deflate? Time will tell.

Someday all the quantitative easing programs must end, and it’s not clear what the consequences will be.

 

Photo Credit: Katerina Hlavata via Flickr Creative Commons