Afraid of the Bubble?

In the last 5 years, you will have heard about bubbles at some point, either from your close friend, investment "guru" or  in the news. Many people keep saying the stock market is in a bubble already. 
I have been watching the markets for very long time, recently did not execute any trades because of this fear. If we are really in a bubble, how will we know? What can we do to prepare for the big bursting of the bubble??

Actually every market also can have a bubble, some more active than others. Industry experts always take the safer stance and warn us if a bubble is imminent, going to burst, corrections going to happen and so on. Personally I like to listen to them and will agree if it is logical. However most of the time, I just do my own research first before taking any action. So should you.

DEFINE A BUBBLE: Markets always go through ups and downs. So everytime there is a correction, doesnt mean a bubble burst. So please "Investment Guru" on TV if you are reading this (which i doubt) STOP beating the drum everytime. A market bubble is usually the result of irrational exuberance, disconnected from the core fundamentals, where prices shoot up due to unexplained demands. 

Best way to look at whether or not there is a bubble is to look at the instrinsic value of a stock which is usually determined by their cash flow, expected growth and risk (liabilities). Naturally if cash flow increase, growth rate climbs, risk drop then the stock price should go up (by right), this cannot be considered a bubble. On the opposite side, if the stock prices go up as cash flow decrease, growth rate is negative and risk is higher, this is a bubble.

For me I like to look at price earnings (PE) ratio and interest rates. See graph below:

    
As you can see, we are no where near the high PE ratios required to start panic. Partly is due to the low interest environment created by the FEDs and this is affecting markets all over the world. Also notice how long term interest rates are inversely proportional to the PE ratio. 

Looking forward into 2015, I do feel interest rates will continue to be low and markets artificially manipulated. So until then I clearly have no worries of an impending bubble. The million dollar question is what is going to happen by the end of 2015 and starting 2016. 
Hopefully by then, I would have reduced my exposure to stocks to 20% in defensive counters, and holding the rest in cash to be deployed when required.