It is a difficult time for investors to remain disciplined. The recent highs in the US equity market have been leading to “altitude sickness” for investors. If you look at the market from a bird’s eye perspective, the market is being traded much higher than you would expect relative to its typical long term value. This is especially the case if earnings are normalized to take high profit margins into account.
The way things look closer isn’t very different. If you spend a lot of your time searching for new stocks, whether through reading or talking in person with other value investors, you’ll notice this. Everyone is having a tough time picking out a lot of interesting stocks. In fact, it’s common for investors right now to spend more time selling than buying stocks. The question of whether or not we’re in a bubble gets asked a lot. However, what is a bubble? There’s probably an academic definition that involves valuations and several standard definitions away from the mean, but this is only important to academics.From the point of view of the investors, a bubble is what happens when a company’s ratio of price to earnings is so high that it becomes tough for the earnings to grow at a rate that matches up with the expectations of investors. To put it another way, because of how expensive the stock is, the investors who have some of it will not be likely to see positive returns for quite a while. Good examples in the past included Sun, Cisco, and Microsoft back in 2000. There are still some stocks in today’s market that are in bubble states. You tend to see a few every year, but right now, there are likely to be more than in most years.We are looking at a lot of stocks that are either fully valued or even overvalued. Valuations, or expectations, about these stocks are typically priced in very optimistic growth situations. However, it’s often hard to tell where a stock goes from being overvalued to being in a bubble. If the economy does not grow as quickly as it is expected to do or if the profit margins aren’t as large as corporations have come to expect them to be, then overvalued stocks and bubble stocks will tend to appear the same. Sadly for value investors, a number of stocks are currently overvalued.As a result, it takes a lot of effort for an investor to keep up levels of discipline and hold tight. It is hard to sell stocks that are overvalued, as every decision to sell leads to future pain. This is because stocks that are overvalued might continue to keep on increasing in value after you sell them. Selling is painful, so we learn not to do it. And we learn to become irrational or if your are optimistic, you can argue we learn to make stupid decision rationally because it is less painful than being rational!