After historic gains, are stocks nearing a bubble?

Federal Reserve Chairman Ben Bernanke fielded the usual questions about inflation, tax cuts and government debt during a trip to Congress last week. Then a new question popped up: Is the Fed creating another bubble in stock prices?

Federal Reserve Chairman Ben Bernanke fielded the usual questions about inflation, tax cuts and government debt during a trip to Congress last week. Then a new question popped up: Is the Fed creating another bubble in stock prices?

Bernanke told the Senate Banking Committee he saw "little evidence" that was happening. But he cautioned: "Of course, nobody can know for sure."

That's the problem with bubbles. You only know you're in one when it pops.

This week is the second anniversary of the bull market that followed the financial meltdown. The Standard & Poor's 500-stock index is in its fastest climb since 1955, doubling since the market bottomed on March 9, 2009. In January and February alone, it's up 5.5 percent, the best start to a year since 1998.

Stock bubbles are famously hard to define. In 1999, for instance, investors thought it was perfectly rational to pay 62 times a company's earnings per share for a technology stock because it seemed dot-com companies couldn't lose. They only realized their error when many of those companies turned out to be nothing more than slick marketing ploys.

After two bubbles in the past 10 years — tech stocks and real estate — investors are suspicious of consistent gains that seem too good to be true. Some worry that the Fed's dramatic measures to pump up the economy mean the market's gains are an illusion. But a range of measurements suggest the market isn't in the midst of a bubble now. Instead, the stock market may simply be back to normal.

"The last two years were the great giveaway," says Stephen Lieber, the chief investment officer responsible for $6 billion in assets at Alpine Mutual Funds. Stocks had fallen so low during the panic that anyone who bought stocks on March 9, 2009, received a once-in-a-lifetime deal, he says. Caterpillar Inc., for instance, closed below $24 that day. It's now above $100.

While stock prices are much higher than they were two years ago, Bob Doll, market strategist for asset-management giant BlackRock, says investors aren't irrationally optimistic.

"Bubbles occur when there are high valuations, evidence of lots of borrowing to lever up to buy something," he says. "When I look around the landscape I have a hard time finding anything that looks like that."

One sign of a bubble would be if stocks rose far beyond what's normal by historical standards, says Bill Stone, chief investment strategist at PNC Asset Management Group. By that measure, it's not happening yet. According to Stone's research, since 1928, the average bull market runs almost five years and gains 164 percent. By comparison, this bull market has barely hit middle age.

The fundamentals of the stock market don't suggest a bubble, either. The S&P 500 index now trades at 17.4 times the earnings of its stocks over the past year. In March 1999, during the tech bubble, the multiple was 30.6.

Corporations are expected to make record profits this year and have enough cash — $2 trillion — to pay bigger dividends and start buying back shares of stock, both of which make stocks more valuable.

"Corporate balance sheets haven't been in better shape over the last 200 years, period," says Joe Davis, the chief economist at fund giant Vanguard.

And there's no ignoring the economic recovery. The economy was shrinking at almost a 5 percent annual rate when stocks bottomed in 2009. Now it's growing at almost a 3 percent pace. Businesses added 222,000 jobs in February, the most since April 2010, and unemployment has fallen almost a full percentage point in three months.

"The economy is absolutely justifying what is happening in the stock market," says Liz Ann Sonders, an investment strategist at Charles Schwab.

Some investors say there isn't a bubble yet but worry that the market is in the first stages of inflating one. Rob Arnott, the founder of investment firm Research Affliates, thinks the stock market is "dangerously" overpriced. He points to Apple, which has a $321 billion market value, making it the second-largest company in the world behind Exxon Mobil. By revenue, profits or payouts to investors, however, Apple fails to crack the top 20, Arnott says.

"They have wonderful products and a finger on the pulse of the consumer like nobody else," Arnott says. "But the second-largest on the planet must mean Apple is the second-largest source of profits. Boy, that's a stretch."

Judged by other measures of value, the companies that make up the S&P 500 look rich. Investors are paying 24 times inflation-adjusted earnings over the last decade. The historical average is 16. That ratio could climb if people push stock prices higher because they expect earnings to catch up. But Arnott believes people are already underestimating larger problems ahead. The U.S. government's $14 trillion in debt and a greater share of the work force hitting retirement are both bound to drag down economic growth. "That's quite a hurricane," he says.

Legendary investor Jeremy Grantham, chief investment strategist of GMO, has a knack for timing. In a letter to investors released in early March 2009, Grantham argued it was impossible to declare a bottom in the stock market but said its steep drop was reason enough to jump back in. He predicted that the combined efforts of the Fed and government spending would spur a stock rally "far in excess of anything justified by either long-term or short-term fundamentals."

Grantham remains a critic of the Fed's stimulus program but isn't willing to say stocks have reached bubble territory. At least not yet. If the S&P 500, at 1,321 on Friday, climbs to 1,500 by October, then watch out. At that point, he says, "it will be a market looking for an excuse to go. On the first piece of really bad news, it will make a determined effort to tank."

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