• The US stock market is pricey, but there’s no bubble, Touchstone Investments strategist Crit Thomas says.
  • There are pockets of speculation, but 2 catalysts could create a widespread market bubble.
  • Thomas breaks down those catalysts and how to position in the current bubbly environment.

The US stock market is looking pricey, but it isn’t in a bubble, according to Crit Thomas, a global market strategist at Touchstone Investments, a firm that manages $26 billion in assets.

The bubbles are instead forming in low-priced and low-volume stocks.

Shares in video-retailer Gamestop (GME) are an example of this. The shares increased 815% from $35.50 on January 15 to $325 on January 29. The surge was driven by retail investors looking to squeeze hedge funds that had shorted the stock.

Smaller amounts of money can really amplify price moves in these types of small-cap stocks, Thomas said. 

"I really don't see these sort of peripheral bubbles as evidence of broad market risk," Thomas said.

Instead, he believes the bubbles are manufactured highlighting that some of the stocks in the bubble fell in price while the bond market continued to rise.

"With respect to these peripheral bubbles, I would not characterise the people that are participating in this as investors," Thomas said. "I would suggest that they are speculators and I differentiate that by essentially they're focused on the price, as opposed to valuation."

A widespread market bubble

Thomas, who witnessed the 1999/2000 dot-com bubble and boom, said there would need to be more broad participation in the market, as well as participation from institutional investors for a rally in the wider stock market to become a full-on bubble.

"It wasn't just retail investors that were pushing up stocks," Thomas said in reference to the dot-com trade. "The institutional investors were in there as well."

He also highlights that in the late 1990s, the large gains in prices happened in large-cap stocks, whereas now, most of the extreme price action has been isolated to small-caps.

Thomas said valuations are high for US large-cap stocks, but not to the point where there is the kind of disconnect that would suggest the broader market is in bubble territory.

For the most part, investors are still using valuations to determine price, Thomas said, which is a positive sign.

When the dot-com bubble was forming, valuations were crazier and companies were being priced on sales because there were no earnings, Thomas said.

Correction territory

No matter how bullish the market might appear, investors should always have a correction at the back of their minds, Thomas said.

"I don't think that there's anything unique about this year from other years in the sense of expecting a correction," Thomas said.

The S&P 500 has hit record highs again this week, having gained around 10% in the space of three months, compared with a 17% gain in the Nasdaq 100 and a 35% increase in the small-cap Russell 2000. 

However, if there were a market correction, Thomas said he would be inclined to buy because the fundamentals are still strong.

The Federal Reserve's monetary policy stance is still accommodative, there is fiscal stimulus and there's a lot of repair still to happen in terms of employment, which are all tailwinds keeping the market healthy, Thomas said.

Buy the dip

If the US large-cap domestic market looks rich, where should investors buy?

Thomas would approach the market with thoughtful diversification.

He describes the S&P 500 as concentrated with a heavy growth tilt and cautions investors against taking big bets on the index.

"As I look at 2021, I see this as a year that's better for consumers than really, necessarily, for the market," Thomas said.

Thomas said investors should diversify towards international and emerging-market stocks. And they should consider some of the "COVID-19 losers" - generally service-based companies that are highly dependent on the health of the underlying economy - as the recovery will likely shift consumer spending behaviors. 

One area to look at is small-cap stocks. He said investors shouldn't be worried about small-cap stocks because of what happened with WallStreetBets and the retail investor frenzy. He said the targeted stocks were those with really low prices, comparable to penny stocks.

Small-caps are more cyclical and more likely to benefit from an earnings standpoint, Thomas said. Valuations look relatively attractive, he added.

In terms of fixed income, it's challenging because of the current near-zero interest-rate environment.

Investment-grade credit has already had a good run, Thomas said. Investors instead could look toward low investment grade, which is cheaper.

He expects that the backdrop will improve for low investment grade, with fewer defaults and with upgrades outnumbering downgrades.

"I think just earning income is going to look more attractive out of the low investment grade versus what you can get today in investment grade," Thomas said, adding that, as always, investors should be cautious and selective when looking for new opportunities.