In his recent article titled Are We In A Stock Market Bubble?, Ray Dalio has developed a set of criteria to identify bubbles in various markets, including stocks, real estate, and commodities. These criteria include high prices relative to traditional valuation metrics, unsustainable growth expectations, an influx of new and inexperienced investors, widespread bullish sentiment, debt-fueled buying, and speculative purchases. Applying these criteria to the current US stock market, Dalio concludes that it does not exhibit the characteristics of a bubble.
Here’s an excerpt from the article:
As you know, I like to convert my intuitive thinking into indicators that I write down as decision rules (principles) that can be back tested and automated to put together with other principles and bets created the same way to make up a portfolio of alpha bets. I have one of these for bubbles.
Having been through many bubbles over my 50+ years of investing, about 10 years ago I described what in my mind makes a bubble, and I use that to identify them in markets—all markets, not just stocks.
I define a bubble market as one that has a combination of the following in high degrees:
1. High prices relative to traditional measures of value (e.g., by taking the present value of their cash flows for the duration of the asset and comparing it with their interest rates)
2. Unsustainable conditions (e.g., extrapolating past revenue and earnings growth rates late in the cycle when capacity limits mean that that growth can’t be sustained)
3. Many new and naïve buyers who were attracted in because the market has gone up a lot, so it’s perceived as a hot market
4. Broad bullish sentiment
5. A high percentage of purchases being financed by debt
6. A lot of forward and speculative purchases made to bet on price gains (e.g., inventories that are more than needed, contracted forward purchases, etc.)
I apply these criteria to all markets to see if they’re in bubbles.
When I look at the US stock market using these criteria (see the chart below), it—and even some of the parts that have rallied the most and gotten media attention—doesn’t look very bubbly.
The market as a whole is in mid-range (52nd percentile). As shown in the charts, these levels are not consistent with past bubbles.
You can read the entire article here:
Ray Dalio: Are We in a Stock Market Bubble?
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