If you follow the markets you’ve probably noticed the words “bubbly” and “frothy” are coming up a lot these days.
They are terms that are normally applied when broader indices like the Toronto Stock Exchange or the S&P 500, or specific sectors like technology or real estate, have advanced beyond what they are really worth. Only the market knows their real worth but the terms suggest a pullback of some degree is expected and they will eventually decline in price to their true values.
Like the word implies, a bubble is more severe because it will eventually pop as it grows, and there won’t be much left afterward. The problem is; you don’t know it’s a bubble until it pops. Good examples of market bubbles include the technology meltdown of 2000 when the sector declined in value by 60 per cent, and the 2008 global financial crisis which cut the value of major exchanges like the S&P 500 in half - all in a matter of weeks.
Bubbly has been used to describe smaller market players like cryptocurrencies and GameStop Corp., but they tend to only impact direct investors. Melodramatic warnings of broader market bubbles - the kind that impact everyone - rarely play out.
The term “frothy”, however, could very well apply right now - either to the broader markets, sectors, or individual stocks in your portfolio. Froth is the foam on your cappuccino or the head on your beer.
Long-term investors usually don’t have to worry about froth. Good investments tend to ebb and flow on their upward trajectory and trying to determine the difference between the current trading price of an investment and its real - or intrinsic - value is difficult and could backfire.
Investment pros like Berkshire Hathaway Inc. Chairman and Chief Executive Officer Warren Buffett use value metrics as signals to sell frothy stocks or buy undervalued stocks at the right moment. The most common value metric is the price to earnings (PE) ratio, which is based on the relationship between a company’s share price and its earnings. Any stock price is a reflection of the market’s confidence in a company’s ability to grow earnings.
The simple formula for determining a PE ratio is dividing a company’s earnings per share into its current share price. If shares are trading at $100, for example, and earnings per share are $5, the PE ratio is 20 times.
A low PE ratio is generally a buy signal and a high PE ratio is generally a sell signal; but determining the dividing line depends on a lot of things including the sector and the individual company’s history of meeting earnings targets.
Interpreting earnings from financial statements can be difficult for the average investor. Earnings results could be skewed by one-time transactions, or companies with strong growth potential could trade at abnormally high multiples in anticipation of strong earnings growth down the road.
Many financial websites offer a tally of buy, sell, and hold ratings from qualified analysts who know how to read between the lines. Some offer analysis or the actual reports but they are usually behind a paywall.
Many retail investors who invest through advisors might not realize the recommendations they receive are based on in-house analyst reports they are ultimately paying for through investment fees.
Determining whether an investment is at risk of being bubbly or frothy also depends on the individual investor. While stocks that trade at high multiples tend to carry more risk, they also have potential for big rewards. A properly diversified portfolio requires a certain element of risk to offset safer investments and boost overall performance. Younger investors are in a better position to take on more risk because they have time to recover if the investment sours, while older investors need to be more conservative since they will need to withdraw funds sooner.
That’s where a qualified advisor comes in - provided fees don’t outweigh the advantages of personalized service.
For those who like to go it alone, many trading platforms offer tutorials on how to interpret financial statements.
Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email firstname.lastname@example.org.