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Are stocks expensive? Is this a bubble?

Yesterday the S&P 500 closed at a record high so it is unsurprising that you see headlines asking if the market is overvalued or is this a bubble? Many pundits are calling this stock market a bubble and predicting doom. In Bank of America Merrill Lynch's April fund manager survey of global investors, a record 83 percent of fund managers said that U.S. stocks are overvalued. In July, Goldman Sachs research highlighted "elevated valuation on almost every metric" in its weekly report on markets.

Is the stock market overvalued?

We firmly disagree that markets are overvalued and we remain bullish on equities. Because interest rates are so low in the US and negative in Europe and Japan, one could argue that stocks look inexpensive. This is one of the reasons why we expect the bull market to continue on. One person that agrees with us is Warren Buffett!

In an interview in May, he explained his reasoning. He basically says that all asset values are keyed off of the risk free rate of Treasuries. If you have low interest rates, the value of your future earnings increases so stock prices look even cheaper. Listen to the interview, it is well worth five minutes of your time.

"If interest rates are destined to remain low... it makes any stream of earnings more valuable from investments worth more money."

Buffett: Stocks a bargain if you think rates stay low from CNBC.

Where are interest rates headed?

So the $64,000 question is: where are rates headed? Like Buffett says if rates stay lower than historic averages, then stocks remain very attractive. However if rates doubled from here in short order, it would be quite bearish. In Buffett's interview, he says "I don't think it's unthinkable that they (interest rates) stay low for a very long time and by low I mean 100 basis point higher than they are now. It's the big variable for investors."

Buffett may have tipped his hand as to where he thinks rates are going. In June, Berkshire invested $377 million into Store Capital (ticker STOR) which is a REIT that pays a 4.5% dividend. Given that REITs trade inversely with interest rates, it shows that Buffett probably thinks that rates are likely headed sideways or lower. If he expected much higher rates, then he wouldn't be investing a slug of cash into REITs.

Are you getting nervous about the stock market? Are you bullish or bearish?

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About the Author: Chris Wang

Chris Wang

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