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Is It Just a Strong Market, or the Bubble, Part 2?

Published: June 10, 2007

THE Standard & Poor’s 500-stock index is close to where it stood just before the bursting of the Internet bubble in March 2000. That makes some investors nervous: Could the market be forming another bubble?

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On the surface, at least, there doesn’t seem to be inordinate cause for concern. Current conditions certainly look different from those of March 2000. But several subsurface issues suggest that we shouldn’t be too sanguine about the possibility of avoiding another bubble.

One factor that suggests a big difference between current conditions and those of early 2000 is the price-to-earnings ratio of the S.& P. 500. The ratio is now 18.1, using S.& P. data on trailing 12-month reported earnings. That’s within shouting distance of the average P/E since 1927, which stands at 16, but far below the 29.4 at the March 2000 market top. This suggests that while the market may not be undervalued, it is not nearly as overvalued as it was when the Internet bubble burst.

Confidence in this conclusion weakens, however, if you take a longer perspective and examine the ratio of the S.& P. 500’s price to average earnings over the last 10 years, rather than to earnings over the trailing 12 months. Clifford S. Asness, managing principal at AQR Capital Management in Greenwich, Conn., says that such a focus makes sense, because 12-month earnings are quite volatile. This helps explain why P/E ratios based on 12-month earnings have such a spotty record of identifying overvalued markets, he said.

“P/E ratios based on 10-year average earnings, adjusted for inflation, make much more sense for this purpose,” he added. And though that 10-year average ratio for the S.& P. 500, now at 27.4, is lower than it was in March 2000 , when it stood at 46.1, it is still at one of its highest levels ever. Other than the years associated with the Internet bubble, in fact, there has been no period since 1929 when the 10-year average was higher.

Another factor that provides solace to some people is investor sentiment, which is certainly less euphoric than it was at the height of the Internet bubble, when stock-picking seemed to be the national pastime. But, again, a look below the surface suggests that you shouldn’t put too much weight on the apparent contrast.

Several academic studies suggest that current sentiment isn’t likely to be low enough to prevent another bubble from forming. One such study, “Overreactions, Momentum, Liquidity and Price Bubbles in Laboratory and Field Asset Markets,” appeared in 2000 in The Journal of Psychology and Financial Markets, now The Journal of Behavioral Finance. Its authors were Gunduz Caginalp, a professor of mathematics at the University of Pittsburgh, and two professors affiliated with the Interdisciplinary Center for Economic Science at George Mason University, David P. Porter and Vernon L. Smith. Professor Smith was one of the 2002 Nobel laureates in economics.

In an interview, Professor Porter said that one conclusion of this study — as well as other such studies of which he is aware — is that investors become largely immune to bubble-causing behavior only after living through the bursting of two successive bubbles. Because of this, the typical pattern is for a burst bubble to be followed by a somewhat less extreme version of the original — a phenomenon that some call a bubble echo. This pattern has appeared so consistently and so regularly in psychological experiments, Professor Porter said, “that you can almost set your clock according to it.”

Does the decline in the real estate market over the last couple of years count as the echo of the Internet bubble, meaning that we needn’t worry as much about another collapse in the overall stock market? Unfortunately not, Professor Porter said. The immunity appears to apply only when the echo occurs in the same, or in a very similar, asset class. The real estate market, he said, is too different from the stock market to qualify.

JUST because a bubble echo is likely at some point, however, doesn’t mean we’re in one right now, Professor Porter added. But he also pointed out that researchers have found that a market decline after the bursting of a bubble echo tends to be larger the more years have passed since the first bubble popped. And even if a bubble has already formed, he said, his research can’t be used to predict when it might burst.

Nevertheless, he said, no one should conclude that a new bubble is impossible just because the Internet bubble is still fresh in our minds.

In an interview, Professor Smith said that while he didn’t think current market valuations were as extreme as those of March 2000, he still believes that stocks are vulnerable to a significant decline. That’s partly why he is holding a good amount of cash in his own portfolio.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.

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