After six years of strong returns, the market suddenly lost about 10 percent of its value in mid-August 2015. In September, after the market had regained some of August’s losses, Yale economist Robert Shiller, a Nobel laureate, told CNBC that the stock market might be in a bubble. "I think the market might do what it did in 2000," he said.
Six months later, the market is roughly where it was the day Shiller made his comments. With plunging oil prices, China’s serious economic troubles, and the ever-present possibility of a security crisis, one can hardly rule out the possibility of a big further drop.
If you remember the past two stock market meltdowns, in 2000 and 2008, you might be tempted to dump your stock investments so you can avoid big losses when the current bubble — if it is in fact a bubble — ultimately pops.
I asked several experts what they thought about this question. They told me that trying to predict market bubbles is generally a fool’s errand. However, there are some steps ordinary investors can take to protect themselves that work whether there’s a bubble or not.
The lessons are a bit different regarding a housing market bubble. Because these are more immediately dangerous to regular people, you should be more restrained in your decisions about housing, especially if local real estate prices race ahead of local rents, or if your life situation would makes it hard to ride things out if housing prices really dropped.
No one knows if there’s a stock market bubble or not
The first thing to remember is that we don’t know if we’re in a bubble right now. Shiller suggested we’re in a bubble, and he’s pretty smart. But there are plenty of smart people who think current prices are sustainable.
"Bubbles are only ‘predictable’ after the fact," writes Princeton’s Burton Malkiel, author of a famous investment book called A Random Walk Down Wall Street, in an email.
We all know about the 2000 dot-com bubble and the 2008 real estate bubble. We like to think that if we’d been there we would have seen them coming. But bubbles are more deceptive than that. Genuinely smart investors lose serious money when bubbles burst. After all, that’s how they become bubbles in the first place: If they were truly obvious, so many people wouldn’t have gotten fooled.
During a bubble, there’s always a plausible argument that higher prices are justified by more favorable market fundamentals. After the dot-com bubble burst, for example, it seemed obviously stupid to bet the farm on Pets.com. But during the 1990s boom, it sure looked like Amazon, Microsoft, and other innovative companies were changing the nature of American business.
The same point applies today. Maybe the possibility of Indian and Chinese growth has spawned unrealistic expectations about the companies that sell goods and services there. Maybe those hopes will actually be realized. Either way, it will seem more obvious afterward than it does right now.
And it’s important to remember that the stock market has experienced solid periods of strong growth that were not bubbles at all. For example, after the stock market boom of the mid-1980s, a lot of people thought the market was due for a fall. Pessimists predicted that the 22 percent, single-day stock market crash on October 19, 1987, would be the start of a big recession and a bear market. Instead, the market shrugged it off, delivering spectacular stock market returns for another 12 years. People who panic-sold in October 1987 expecting further declines missed out on big gains instead.
Even if some financial experts might be able to recognize stock market bubbles, you and your financial adviser probably aren’t in this group. If you’re saving for retirement, what you care most about is stock market returns over the long run. Neither excessive alarmism nor undue optimism is helpful.
Lifelong saving is the best defense against stock market bubbles
The key to investment success is to save 10 to 20 percent of your gross income over the course of your career — regardless of what the stock market is doing. You’ll ride some serious upswings, and you’ll experience some stomach-churning declines. But in the long run, you’re likely to do fine, or at least as well as you would do following any other available strategy that doesn’t involve a time machine.
Don’t panic-sell when the market plummets. Don’t get overconfident when the market soars, either.
Avoiding the cacophony of financial media can help you stay on course. As my University of Chicago colleague Richard Thaler told me: "Never watch a financial news network. ESPN is much better for your financial health."
If you live below your means during your working years, you’ll build up a nice cushion against a major stock market downturn. If you get lucky, you might enter your golden years with greater wealth than you expected. As worst-case scenarios go, that one isn't so bad.
As you age, you can also reduce your risk by somewhat reducing your exposure to stocks — which offer higher returns but are more volatile. A "target date" fund set to your date of likely retirement can do this automatically for you. There are more details on how to do this in my new book (with Helaine Olen), The Index Card.
Your stock market returns are likely to be lower than in the past
Today’s high stock prices don’t necessarily mean that stocks are about to crash. But they do mean you should expect stock market returns to be a bit lower in the future than they have been in the past.
"If someone gives you a rule of thumb that you can expect 7 percent real returns in the stock market over a long-term, this is wrong," writes Dean Baker, an economist at the Center for Economic and Policy Research. That’s the average rate of return over the past century, but these generous returns occurred at a time when stock prices were often less than 15 times corporate earnings.
Today, by contrast, stocks are worth more than 20 times earnings. And that means we should expect the rate of return on stocks to be correspondingly lower. Baker says current stock values imply that the inflation-adjusted rate of return is likely to be below 5 percent over the long run.
That doesn’t mean you should run away from stocks. Other options, like bonds and money market funds, are also offering lower returns than they used to. But it is a reason to save a little more and spend a little less in the expectation that the stock market won’t be going like gangbusters as it did in the late 1980s, the late 1990s, or between 2009 and 2015.
Be cautious about buying a house when prices are high
I don't believe ordinary investors should spend much time wondering if the stock market is overvalued. I’m more cautious when it comes to housing, because a fall in your local housing market can do you greater and more immediate harm.
The money you put down on your house is different from the money you put down on an index fund for your retirement. Your house is the most leveraged, illiquid, and undiversified investment you will ever make. So a 10 to 20 percent swing in your local housing market can have an outsize impact on your wealth.
Housing runups and bubbles are distinctive risks for a second reason, too. Most people don’t need to draw on much of their stock portfolio until they’re at or near retirement. Even then, people draw down their wealth gradually in their 70s, 80s, and hopefully beyond.
In contrast, buying a house is an all-or-nothing proposition. And depending on what happens in your life, you might need to sell unexpectedly. You or your partner might lose a job. You might have a child or get a divorce. You might have to move to a new city to find work. If the local housing market drops just as you need to sell your house, that can be financially devastating.
How vulnerable you are depends a lot on your own life situation. If you’re confident you’ll be able to stay in the same house for a decade or more, you can ride out a bursting housing bubble in the same way you can ride out a bursting stock bubble. You’re less vulnerable if you are a tenured professor than if you work in a more volatile profession. Employment is not the only variable in play, either. If your marriage is troubled, that’s harder to talk about, but it also increases the risk that a separation will force you to sell earlier than you expected.
The best defense against these dangers is to be patient — especially if there has recently been a runup in the local housing market. The more you feel yourself stretching to buy a house, the more it makes sense to rent longer or to buy a more modest home. A vanilla fixed-rate mortgage with a 20 percent down payment is your best bet. These monthly payments, plus your property taxes, plus a few percent annually for repairs and maintenance, shouldn’t exceed 30 percent of your income.
Pay attention to the ratio of home prices to annual rents for similar properties. Dean Baker suggests that when this ratio exceeds 15 to 20, "caution is in order." Readily available data isn't perfect. Typical data compares median home prices to average annual rent. In areas that include a preponderance of hugely expensive homes, this can be misleading. But if this ratio creeps well above an area’s historic average, think twice before buying.
One final risk arises when your house rapidly appreciates. That risk is you. It’s tempting to spend too much by drawing on your home equity. During the Great Recession, millions of Americans learned that home equity can fall as quickly as it rises. I’m leery of home equity loans for a luxurious kitchen upgrade, a vacation, or a costlier car than you would otherwise drive. In this, as in so many things, living below your means is the best way to achieve financial security.
Correction: This article originally misidentified Dean Baker's affiliation.