When you look at the historical returns of the S&P 500 it’s easy to dismiss concerns of a stock market bubble. Look at the past 90 years of the United States stock market and it’s easy to look past the volatility. It’s often claimed “the stock market always goes up”. As a result, the growth potential of the S&P 500 is often used to dismiss any notion of a long-term crash. This is especially when you consider the S&P 500’s 10-year bull run. It’s hard to consider the potential that the S&P is in a bubble and could suffer the same fate of the Nikkei 225.
S&P 500 vs Nikkei 225 Valuations
If you look at the Japanese Nikkei 225 over the past 30 years you can see that it has never recovered to its 1989 high. This is a little disturbing. Even for the long-term investor, that focus on the long-term. There are visualisations that show if you invest for a period of 20 years then you pretty much never lose money. Perhaps people said the same thing about the Nikkei 225. As such this is a strong come-back by sceptics of people who say the stock market always goes up. This made me curious about why the Nikkei never recovered and what makes the S&P 500 a different story.
Disclaimer: This article should not be considered as financial advice. You are responsible for your own financial research and decisions. When Investing capital is at risk.
Japanese stocks surged in price between 1986 and 1989 and in just 3 short years the price of the Nikkei nearly doubled from 16,392.74 in 1986 to 34,050.78 by 1989 (the peak). A $100,000 investment in Japanese large-cap stocks in 1970 would have turned into $5.7 million by 1989. The index then fell by:
-39% to 29,437.18 in 1990
-3.6% to 24,295.57 in 1991
-26% to 18,109.08 in 1992.
In 2017 the S&P was valued at 2449.08, if this was following the same bubble style trajectory of the Nikkei in 19899 the 2020 figure would be closer to 5086 compared to its current approximate figure of 3041.This demonstrates that whilst it may be peaking and that a strong bear market is due, it’s not the same as the Japanese stock market bubble.
Nikkei 225 Price to Earnings (PE) Ratio in 1989
One key aspect that separates the Nikkei from the S&P 500 is the p/e ratio. The average Nikkei PE ration in 1989 was 60x that of trailing 12-month earnings, compared to the global average of 14 to 16. This figure alone highlights the enormity of the bubble.
As of September 2020, the PE ratio for the S&P 500 is around 28.70. Which as you can see from the graph below is peaking but to a level of tolerance that we have seen many times historically. As you can also see the P/E ratio is not even close to the levels caused by the .com bubble in the early 2000s.
Investing In The Japanese Nikkei 1987 To 1991
One of the concerns of investors is that they will invest all their money and then get back less than they put it. The Japanese market bubble you might make you warry of starting to invest in the S&P 500 today.
If you would have invested solely between 1987 and 1991 you would still not have recovered your money. Many investors may well have got wrapped up in the excitement of the bubble and done just that. By contrast, if you’d have invested in 1986 or before you would be sitting on a positive return. As if you would have invested in 1992 or after.
4 Actions You Can Take To Avoid Losing Money In A Stock Market Bubble:
The S&P 500 could well be moving into bubble territory. It may well crash but there are some actions you can take. Even in worst-case scenarios can protect investments and permit a positive return.
There is always a probability, no matter how small that the S&P 500 could turn out to be the next Nikkei 225. This possibility strikes fear into the heart of every investor. This may make you reluctant to invest. Worse, to start messing around with your stock portfolio in ways that damage your return.
If you haven’t got a stock portfolio yet, then get my free ebook. You can get started with investing today, by opening your investment account in just a few steps. With this in mind, here are 4 main ways I could rationalise out my investment journey. This importantly takes risk into consideration.
1. Dollar-Cost Averaging
You might look at the Japanese stock market bubble through the investment lens of the 3 year peak. If you think about your own investment journey, would rarely only invest for a 3 year period. It’s unlikely you would have invested the entirety of your net worth in 3 years.
The chances are that you will have drip-fed money into the market throughout 10, 20, or 30+ years. This is known as dollar-cost-averaging. This means you can invest through on the stock market dips and corrections. This allows you to take advantage of cheaper prices before riding the wave back up to the top.
Some might say that dollar-cost averaging is just delaying risk. In theory, you could invest all your money over a 5-10 years period. The stock market could subsequently crash. Meaning you might as well have invested a lump-sum from the beginning.
In reality dollar-cost averaging should reduce the risk of this. Realistically speaking, who has all the money they want to invest right now anyway? It actually takes time to save and invest.
2. Dividend Reinvestment
In the extreme example, would have invested the majority of your money between 1987 and 1991. The the chances are that following this strategy you will make up for those losses over time. Especially when you add dividend re-investment to the mix. The FTSE 100 is a perfect example of this.
The FTSE 100 in 1999 the capital growth rate between 1999 and 2017 was just 1.1%. This picture drastically changes when introducing dividend reinvestment. The returns increases to an annualised growth of 4.6%.
This still might not seem like much until you factor in almost 20 years. The total return difference for the whole period would have been 20.4% without reinvestment. Factor in the reinvestment and it translates to a whopping 119.3%.
This highlights that you don’t need a surging bull market to make investment returns. As you continue to invest and reinvestment through the peaks and troughs of the stock market, you can grow your returns by taking this simple action.
MSCI World 1993 to 2018
The power of dividend reinvestment can also be demonstrated by looking at the MSCI World index. If you would have invested $1000 in 1993 the capital growth would have been $3,231 by 2018; an average annual return of 5.9%.
But the picture changes again once dividend and the miracle effects of “compounding” are included. By reinvesting all dividends, the same $1,000 investment in the MSCI World would have produced a notional return of $6,416. This represents an annualised growth of 8.3%.
You can see this impact across various global indices since 1993. It can be the difference between a profit and a loss in some instances such as MSCI China.
3. Geographical Diversification
Still not convinced the United States is not in a Japanese style asset bubble? Then there are a couple of things you can do to manage the perceived risk.
There are other examples of where this has occurred. You may have invested in the Italian MIB over the past decade. This index has struggled to grow since 2008/09. To balance this out you may also have been invested in China. Which has experienced meteoric economic growth of over 10% a year on average since 1987.
4. Balanced Asset Allocation
Ensure you have a bond allocation which is congruent with your risk appetite. Bonds have an inverse relationship with stocks. As stocks fall, bond prices increase and vice versa. As the price of stocks increases you can sell some stocks and to rebalance your portfolio with bonds.
Then as prices of stocks fall, and bonds go up. You can then sell off your bonds to increase your holding of stocks, which can be purchased at a cheaper price. This can also be done by holding a stock portfolio such as VTSAX and a bond fund such as VBMFX.
How To Diversify Your Asset Allocation Strategy
To simplify this approach you can invest in a fund which does this for you, by maintaining the balance. For example, the Vanguard Lifestyle 60% Equity Fund A Ac, which is 60% stocks and 40% bonds.
This approach will most likely provide consistent positive returns, in turn for a reduction in volatility. You will experience less dramatic growth in exchange for a smoother investment journey. You can also see the 8 index tracking funds that make my own shortlist.
Historical Stock Market & Housing Bubbles
To some extent, most of the time people don’t realise they are in a bubble until it pops. Although I remember quite clearly telling people that Bitcoin was a bubble not too long ago. This is because bubbles are characterised by a rapid growth in value that far supersedes their intrinsic worth.
This Japanese index is guilty on both of these counts. It was characterised by rapid growth from 1986 to 1989. The p/e ratios far outstripped the earnings of the companies. Here are some of the greatest bubbles of all time.
Tulipmania (1637).
South Sea (1720).
The Great Crash (1929).
Japan (1989).
DotCom (2000).
U.S. Housing (2007).
Bitcoin (2017).
The US stock market is potentially overvalued but there is intrinsic value in it’s stocks. Especially in the technology stocks, driving up the value of the S&P and Nasdaq. This is because data and technology is now one of the most valuable resources. Demand for data and technology is only going to grow.
Is The US Stock Market In An Asset Bubble?
The flip side of this is that just 5 technology companies now make up 20% of the S&P 500 and this is a dangerous weighting. Stocks could easily crash or develop into a bubble if these stocks become overly inflated in value and/or their earnings decrease.
Regardless of the potential stock market bubble, I feel that by a consistent, unemotional and logical approach to investing will provide favourable returns. By investing in moderation over time and in a geographically diverse portfolio this can outweigh the risks of investing in a stock market bubble. This is one of 3 Reasons Why The FTSE Global All Cap Index Is Better Than S&P 500.
How To Hedge Against A Nikkei 225 Style Asset Bubble
Are stock market bubbles are making you anxious about investing? The good news is that there are more balanced or even defensive funds. These are funds that automate and focus your fund away from less risky growth assets. Instead they tailor your investment approach to assets such as property and REITs.
Download my 5 UK Balanced Funds by clicking here. (US Version: here).
Download my Defence Funds by clicking here.
Trackbacks/Pingbacks