Have you heard the story about the frog dropped into a boiling pot of water? As the story goes, if you drop a frog into a pot of boiling water, it will jump out of the boiling water, and survive. This same story tells us that if you put a frog into a lukewarm pot of water, and then slowly raise the temperature… you’ll soon be having frog legs for dinner.
Turns out, this urban legend is completely false. When subjected to warming water temperatures, a frog will simply jump out when the water becomes too hot. Frogs aren’t so stupid after all.
So much for the wisdom of old stories!
This urban legend may be untrue, but I still like it because it reminds me that gradual economic changes can be almost unnoticeable when you’re in the middle of them. Distorted financial behavior can eventually become completely normalized over long periods of time.
This is essentially how investing bubbles form. Investor behavior gets slowly distorted over time, all the while believing it “normal” by the many market participants.
Like frogs, investors aren’t completely stupid either. They know the risks involved, and once the water gets “too hot” they’ll jump-out, just like our fabled frog. This “jumping-out” is what causes asset prices to decline, when investors sell. Eventually that decline turns into a route, and then the route becomes a full-blow panic. This is how bubbles break.
The question is, are we in a bubble right now? Is it time to jump out of the water and sell my stocks? Or, is the economy giving investors a “Green light” to keep investing?
A Question Of Leverage
As I mentioned in a previous post, the Shiller PE ratio is near an all-time high. This is certainly worrisome because the Shiller PE indicates that stock prices are at very elevated. Elevated prices typically mean lower future returns, so it might not be a good time time to retire early.
However, the fact that stocks are trading at elevated levels is NOT an indicator that the market will crash tomorrow. Far from it in-fact.
Too much leverage is typically a better indicator of an overheated economy, or an overheated stock market. Excessive leverage eventually causes crashes like the Housing Bubble (2008), the Asian Financial Crisis (1997), or the Roaring 20’s Stock Market Bubble (1922-1929).
Household debt levels (for example) could be one cause for concern, as they’ve been growing steadily since 2013:
Debt levels are only one small piece of the leverage picture however. Incomes have also been climbing steadily too, so the ability of the consumer to make payments (aka debt service) looks very healthy right now. As a percentage of disposable income, debt service levels are the best they’ve been in decades! The average consumer should be able to make payments on their debts without a problem!
The U.S. consumer appears to be in very good shape, financially speaking. If we look at bank deposits, it appears consumers have plenty of saved money. Savings rates improved significantly during the pandemic, which means consumers have some very full savings accounts right now:
Indeed, banks have been reporting rising deposits and loan delinquencies near all-time lows. This is one of the reasons why bank earnings have been so good lately — Everyone is paying on their loans!
Simply put, higher savings rates and pandemic stimulus money put a lot of dollars into consumer hands. A large chunk of those dollars are now sitting in bank accounts, but a large number of dollars also made their way into to the stock market. Essentially flooding the stock market with money, and causing stock prices to rise.
What about margin debt though? Could stocks be over-juiced from too much margin debt? That certainly is another area of potential concern, but margin debt still appears to be at relatively reasonable levels too:
Honestly, nearly any economic indicator I can find is currently giving a “Green light” to the charging stock market bull. It’s saying, “Keep on going! Keep buying more stonks!”.
The economy is still recovering from the pandemic, and there’s nothing that indicates a market pullback is imminent (other than some rather elevated stock prices).
But stock prices have been extremely high before, and they can remain at elevated levels for a very long time. It’s certainly no reason to go selling unnecessarily! To quote the famous economist John Maynard Keynes, “Markets can remain irrational longer than you can remain solvent.”
What Might Cause A Investing “Red Light“
Inflation, of course, is the one economic area that everyone is concerned about. It’s not just elevated stock prices either — Prices at the pump, and at the grocery story have been rising steadily this year. The CPI (Consumer Price index) is up 5.4% from where it was a year ago (the most recently published numbers).
Thankfully, stock prices have been rising faster than consumer prices, so those of us living off our assets are still in pretty good shape.
Housing prices have also been rising rapidly — The Case Shiller housing price index is showing a 19.7% annual gain in home prices. We probably have low interest rates and full bank accounts to thank for those big price gains, but at some point the Fed is going to call a “Red Light” and bring this party to a sudden and immediate stop.
Sooner or later, The Fed is going to want to raise interest rates. Rising interest rates usually have an inverse relationship with stock prices — When interest rates fall, stocks rise. When interest rates rise, stocks fall.
So, when The Fed finally gets around to raising interest rates… that’s when the stock market party ends. It’ll be time for all the little frogs to jump out of the water.
For now at least, this squid game isn’t over. It appears the economy is still giving a very green light to investors, telling them to keep playing the game. I see no reason to sell off my stocks, rebalance into bonds, or go to all-cash at this time.
This stock party might still have some life left in it!
Of course, this is all my own opinion, and should not be construed as investment advice. I just call it like I see it. Last time I checked, I have NO ability to predict the future! Definitely talk to your financial advisor before making any financial decisions.
What do you think? Should I stay fully invested, or start moving into cash? Leave a comment below!