The Beginning Of A New Stock Market Bubble?

Last update on Feb. 6, 2017.

Image Credit: Yuliya Evstratenko / Shutterstock.com

 

At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, I’ll also explain why we could see a stock market bubble soon.

 

January Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of January 2017 were as follows:

 

Last Month

Last 12 Months

Since Apr 2013

Slightly Aggressive

-1.5%

+16.8%

+72.9%

Balanced

-1.3%

+15.2%

+60.7%

Slightly Conservative

-1.1%

+13.4%

+49.1%

Moderately Conservative

-0.8%

+11.5%

+38.3%

Very Conservative

-0.6%

+9.6%

+27.8%

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

 

Last Month

Last 12 Months

Since Apr 2013

RBC Select Aggressive Growth

0.0%

+9.6%

+48.0%

TD Comfort Aggressive Growth

-0.3%

+12.5%

+39.7%

CIBC Managed Aggressive Growth

-0.1%

+6.5%

+40.0%

Canadian Couch Potato Aggressive

0.0%

+4.2%

N/A

In contrast to our competitors, MoneyGeek’s Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian preferred stocks (through ZPR.TO) and Canadian oil and gas stocks (XEG.TO). If you would like to take a look at our portfolios, I invite you sign up for our free regular membership.

In January, MoneyGeek’s portfolios underperformed their competitors. The main culprit was XEG.TO, which went down by 8.6% during the month. Since XEG.TO invests in oil and gas stocks, and since oil prices did go down slightly last month, you may have expected XEG’s share price to have fallen. I think, however, that because oil prices fell only slightly, XEG’s move is largely irrational.

Let me reiterate that I fully expect MoneyGeek’s portfolios to periodically experience months like January where they’ll underperform. However, I believe that our portfolios will continue to outperform in the long term.

Finance news in January, as with mainstream news, was dominated by the actions of Donald Trump. The U.S. dollar dove when Trump said the U.S. dollar was too strong. The Bank of Canada warned that Trumps’ policies could significantly hurt our economy. Pharmaceutical stocks dove as Trump repeatedly claimed that drug prices were too high.

So far, most of Trump’s actions have served to undercut confidence in the government and in the global economic outlook. But while most finance professionals have recognized the dangers, stock markets have nonetheless refused to sell off. In fact, I think it’s possible that we’ll see the beginnings of a new stock market bubble.

In the rest of this article, I will explain one simple reason why such a bubble could form. Regular readers may notice that the scenario I’m presenting is very different from the one I presented a few weeks ago. I’m not contradicting myself - I merely believe that both of these scenarios are possible.

 

Potential For A New Stock Market Bubble

There is one main reason I think a stock market bubble could develop, and that is Trump’s plan to drastically cut taxes for the rich. If he follows through with that promise, there will be two large consequences. First, it will drastically increase the budget deficit, and second, it will put more money into the hands of the rich. Both of these consequences could serve to inflate the stock market. Let me explain why.

First, let’s talk about the effect of the rich getting richer. One of the biggest differences between the rich and the rest of us, is that the rich tend to save a much higher portion of their income. Some estimate that the top 1% of earners in the U.S. save about 50% about their income, while the rest of us save less than 10%.

Therefore, if Trump cuts taxes for the rich, the rich will probably save a large portion of that new money. Of course, the rich will try to invest their savings instead of letting the cash sit idle in their bank accounts. But then they’ll face a question: What should they invest in?

The world has only a handful of investment classes that are big enough to absorb a large influx of money - bonds, commodities (most importantly gold), real estate, and stocks. However, not all of these options are attractive. A large tax reduction would lead to a large budget deficit, and as I’ve explained before, such a deficit would lead to rising inflation and lower bond prices.

The rest of the investment options all theoretically protect the investor from inflation, so I believe the prices of all of them will rise as the rich pour money into them. However, I believe stocks will receive the most money out of these investment classes for two reasons: first, because it has the best long term track record of generating returns, and second, because it’s been some time since we have had a stock market bubble.

The other two remaining investment classes - gold and real estate - have had bubbles in relatively recent years. Gold prices soared to about $1,900/oz in 2011, when investors became overly anxious about inflation due to perceived money printing. When high inflation never materialized (read my explanation why), gold prices crashed to about $1,100/oz, and it has more or less stayed there since. Real estate had its own bubble which peaked around year 2006, and the ensuing crash caused the great financial crisis of 2008.

Because of the recency of these bubbles, I believe investors will hesitate to put too much money into gold and real estate once prices go higher. Such hesitancy will probably prevent another bubble from developing in those investment classes. Indeed, history shows that a significant amount of time has to pass before the same investment class can experience a bubble again.

While real estate and gold have experienced bubbles recently, it has been nearly 20 years since we experienced the peak of the last stock market bubble, which occurred in 1999. Though we did experience a drastic selloff of stocks in 2008, the market had sold off from a reasonable level, which allowed it to recover its losses in short order. That quick recovery is potentially giving investors comfort that they would recover their losses quickly, even if stocks were to crash again soon.

Such psychological factors are hugely important to the formation of bubbles, because bubbles are fundamentally a psychological phenomena - investors have to convince themselves that they can’t possibly lose by investing in the stock market.

In my opinion and in the opinion of many good investors, the stock market is expensive, but not yet in a bubble. But if stock prices continue to rise as money from Trump’s tax cuts finds its way to the stock market, we could soon find ourselves in the midst of a bubble.

Of course, there’s no guarantee that this will happen. Since bubbles are psychological phenomena, anything that deprives people of confidence could prevent the bubble from developing. For example, if we have a global recession due to a trade war, investors might become too cautious for a bubble to develop.

But barring any such psychological blows, I believe there’s a good chance that we’ll see a new stock market bubble soon. This is something I’ll continue to think about.

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