It’s widely accepted the US stock market, AKA Wall Street, is currently overpriced or overvalued.

That means the benchmark S&P500 index (which tracks the ups and downs of a basket or portfolio of hundreds of America’s biggest companies) is potentially due for a drop in value, or a fall.

The multi-trillion-dollar question is whether the drop will be shallow or deep?

If the drop, for example, results in what traders call a “correction”, where stocks drop 10 per cent or more from their recent peak, it will cause considerable pain. Most, however, would view that as necessary pain to sustain a long-term upward trend in stock values.

If the drop was much deeper than that — what some may term a crash, the degree of pain, and the eventual recovery, comes with significant uncertainty.

Before we look at that, though, there’s another critical question to answer: is Wall Street in “bubble” territory?

It’s critical because the answer has implications for millions of Australians with retirement nest eggs, and those invested in shares. And, of course, financial markets crises have a bad habit of leading to job losses, especially in the financial and technology sectors.

Howard Stanley Marks is an American investor and writer. He also co-chairs Oaktree Capital Management, an investment firm with $US1 trillion of assets under management. So, when its chair “ponders” the current market stage, it’s worth paying attention.

Asset markets tend to move in cycles. Those cycles are known widely as “bull” and “bear” markets, or sustained periods of heightened interest, or lack of interest, in stocks more broadly.

But first, let’s look at the term stock market “bubble”.

“For me, a bubble or crash is more a state of mind than a quantitative calculation,” Marks notes in a public memo titled On Bubble Watch.

“In my view a bubble not only reflects a rapid rise in stock prices, but it is a temporary mania characterised by — or, perhaps better, resulting from — the following: highly irrational exuberance, outright adoration of the subject companies or assets, and a belief that they can’t miss, massive fear of being left behind if one fails to participate (”FOMO”), and resulting conviction that, for these stocks, there’s no price too high.”

That last point, “there’s no price too high”, is crucial, Marks says.

He explains it this way: “When you can’t imagine any flaws in the argument and are terrified that your office-mate/golf partner/brother-in-law/competitor will own the asset in question and you won’t, it’s hard to conclude there’s a price at which you shouldn’t buy.”

So that’s a “bubble”. It’s most investors throwing caution to the wind.

We have been in bubble territory before

We’ve seen this before.

For example, the tech-media-telecom bubble, known as the TMT bubble, began in the late 1990s. It burst in mid-2000.

The other obvious example is the US housing bubble that led to the global financial crisis.

British historian Niall Ferguson described the euphoria at the height of the pre-GFC bull-run as “collective delusion”.

So how do those on the frontline of Australian financial markets view current investor psychology?

“Well, there’s certainly exuberance in the market,” MooMoo Australia’s chief commercial officer Michael McCarthy told ABC News. “In fact, in post-US election trading there’s very clear signs of euphoria. And of course that calls to mind the famous market saying that bull markets are born in despair and die on euphoria.”

Indeed, as Marks explains, one can argue based on this reading of the stock market, both in Australia and overseas, that a major downturn is imminent.

“The first stage usually comes on the heels of a market decline or crash that has left most investors licking their wounds and highly dispirited,” he says. “At this point, only a few unusually insightful people are capable of imagining that there could be improvement ahead.

“In the second stage, the economy, companies, and markets are doing well, and most people accept that improvement is actually taking place.

“In the third stage, after a period in which the economic news has been great, companies have reported soaring earnings, and stocks have appreciated wildly, everyone concludes that things can only get better forever.”

But Howard also says that the greatest bubbles usually originate in connection with innovations, mostly technological or financial, and they initially affect a small group of stocks.

“But sometimes they extend to whole markets, as the fervour for a bubble group spreads to everything,” he says.

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What does the future hold?

Here’s where what’s known as fundamental stock analysis is crucial. How can you measure the emotion or psychology of a market as a whole? You can’t.

Instead, you can gather information on the value the market is currently assigning to stocks and what the stock, or companies themselves, have reported publicly to the market.

To complicate things a little, the value the market ascribes on a stock now is based on analysts’ forecasts of future earnings — say, over the next six to 12 months.

“That would be the forward-looking P/E,” Michael McCarthy says.

The P/E is the price to earnings ratio. It’s the price of a stock divided by its earnings, or a measure of a company’s share price relative to its earnings per share.

A relatively high P/E tells us a stock is expensive.

“At the moment, with a [average S&P500 P/E] reading above 24, we are at extended levels,” McCarthy says.

Outside of the COVID-19 pandemic emergency, he adds, “we’re at the highest price-to-earnings ratios for the S&P 500 in more than 10 years”.

The S&P500 is Wall Street’s benchmark share index.

AMP’s deputy chief economist Diana Mousina says she can “easily conceive” of a 20 per cent peak to trough crash in Australian share valuations.

“Given the risks to [global] trade and higher bond yields, especially in the near term,” she says. 

“It’s what happens after that. Does the share market bounce back? Our view is that the US and the Australian share markets will still end the year higher than where it started.”

And, according to US-based Federated Hermes chief investment officer Stephen Auth, investment firms would be well-placed to reinvest in the market in the event of a downturn.

“Potential surprises for the market in 2025 seem balanced; staying tilted toward stocks, with cash in reserve for a correction if it comes,” he wrote in a note this week.

As for right now, there’s a list of reasons Auth points to to justify a further increase in global stock prices: “The planned omnibus ‘Trump Agenda’ bill gets passed faster than anticipated. ‘Tariff chess’ works out better than forecast. Inflation drops and the Fed’s forward (lower) policy path becomes firmer. [And] Geopolitical risks decline in Ukraine and the Mideast.”

And the US dollar could begin to soften as well, he says.

And Australian investment experts say the bulls are running.

“You can’t argue with the market; the market is running, there’s no two ways about that,” Michael McCarthy says.

But it’s worth remembering: a bubble can pop in an instant.