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Why stocks could be in bubble trouble

I'm just going to say it: Stocks aren't cheap. That doesn't mean they can't keep rising. But investors should acknowledge the risks.

Fundamentals seem to matter less and less, with both corporate earnings growth and economic data rolling over. Instead, a combination of ebullient sentiment, a continuation of ultra-low interest rates and minimal inflation are all supporting increasingly stretched valuations.

In some areas, one could argue we're deep into bubble territory.

Just look at the Biotech iShares (IBB) exchange-traded fund, an area of white-hot interest for the risk-takers. The ETF is up more than 531 percent from its financial crisis lows and is up nearly 44 percent from its last significant pullback in October. Compare that to S&P 500's 214 percent and 15 percent gains over the same periods.


As a result, the price-to-earnings ratio for biotech stocks, as a group, has swelled to 50x compared to the S&P 500's current valuation of 17x (which itself is at levels not seen since 2004). Moreover, nearly 75 percent of biotechs in the Nasdaq Biotech Index have no earnings at all and just five companies -- Gilead (GILD), Amgen (AMGN), Shire (SHPG) and Celgene (CELG) -- are responsible for 83 percent of the $31 billion in annual earnings that are made.

Putting it all together, only 41 companies in the biotech index are profitable, which means the other 73 percent are losing money. It also means investors are piling into companies that aren't profitable at extreme valuations -- bringing back memories of the dot-com melt-up.


This matters for everyone because a big part of the stock market -- as illustrated by the NYSE Composite Index in the chart above -- topped out last July and has been sliding sideways ever since. Much of the progress in the other indexes, such as the Nasdaq Composite, has been driven by biotech and other frothy areas. The Nasdaq includes some 270 biotech stocks.

Federal Reserve Chairman Janet Yellen was concerned enough about the situation last summer to specifically call out biotech stocks as an area where valuation metrics appeared stretched. Metrics in "some sectors" were again noted as stretched in her testimony to Congress in February.

But when asked about biotechs as well as social media stocks during last week's post-meeting press conference, Yellen deferred, saying she didn't "want to comment on those particular sectors." Maybe she's frustrated that her prior warnings were ignored. Maybe she's nervous about pricking a price bubble. Or maybe she just realized that it wasn't appropriate for monetary policy officials to be giving such specific commentary about the stock market.

Whatever the motivation, investors don't seem worried despite some profit-taking in the IBB this week.

That may change as the second-quarter earnings season starts in two weeks. Deutsche Bank strategist David Bianco recent cut his full-year real 2015 S&P 500 earnings per share growth forecast into outright negative territory due mainly to the negative impact of the recent strengthening of the U.S. dollar.

As a result, the only way he sees current stock market valuations as sustainable with the Fed preparing to raise interest rates later this year is if 10-year Treasury yields stay below 3 percent or so through 2016 (from 1.9% currently).

If this happens, which seems likely given the Fed's repeated guidance that rate hikes are likely to be slow and gradual, there could be further upside in areas like technology and health care including biotech -- both of which are sectors that are somewhat insulated from currency market dynamics.

Maybe areas like biotech are in a bubble. But as long as investors keep buying, it can keep expanding.

For the overall market, Yellen noted that valuation measures are on the high side but not outside historical ranges. That's true, when looking at forward earnings. But when looking at an alternative measure -- median S&P 500 price-to-sales -- at 2.1x, the current valuation is at the highest level in history. Other measures are at the highest level since 2000.

As they say: Buyer beware.

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