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An equity bubble in the making?

According to Richard Thaler, the father of behavioural economics, bubbles are formed “when asset prices exceed a rational valuation of the securities being traded.” The supporters of the Efficient Market Hypothesis will argue that it is impossible to judge a rational valuation for an asset and impossible to call when the valuations are actually in a bubble. Let’s look at the past one-year chart of the S&P 500 Index. How can one call the correct valuation for a bubble to occur? Was it the high in March, was it the low in March, or was it the first rebound after March?

Chart sources: Federal Reserve Economic Data (FRED)

Central banking stimulus across the world seems to be fuelling asset bubbles. Valuations are extended and have reached levels close to the Tech Crisis of 2000. But bubbles aren’t simply a function of valuations and asset prices. A vital element of a financial bubble is the euphoric human emotion creating a mania. Additionally, financial bubbles are relative to other asset classes – usually investors pile into a single asset class to create a bubble. Incredibly high asset prices are generated rather by the traders’ enthusiasm than by economic fundamentals. The asset prices thus reflect irrational beliefs and expectations of the market participants than the intrinsic valuation of the underlying security. To better understand if we are in a bubble at the moment, we need to look at the previous bubbles and the highs in stock markets.

Chart data extracted from FRED

Central banks across the world had started injecting monetary stimulus in the markets towards the start of 2020, leading many investors and especially market bears to believe that the Federal Reserve and its counterparts have created bubbles. M1 and M2 short-term money supply indicators in the US dramatically rose since 2019. Unfortunately, most of the money supply made way into the financial assets than retail/capital spending to create inflation. Inflation is directly linked to money supply – more money chases fewer goods, creating inflation. But an essential aspect to generate inflation is the velocity of money (i.e. how many times does money exchange hands?). While M1 and M2 have risen, the velocity of money has declined.

While inflation in the broad economy does not persist, there is inflation in the asset prices. Before the pandemic hit, we were witnessing the longest bull market in history. The S&P 500, Dax, and other indices were reaching all-time-highs on the back of share buybacks and due to the availability of cheap credit. I wrote about the causes of the high stock market levels despite a failing economy in an earlier piece here. Pre-Covid levels of the stock market were not showing the true signs of a bubble, although now, I believe that the stock market does exhibit symptoms that it might be in a bubble.

All previous bubbles, from the Tulip Mania, the Tech Bubble, the Japanese Real Estate Bubble, to the Chinese Manufacturing Bubble, were driven by the euphoria of investors which made them rationalise their irrational beliefs. Everybody, including retail investors, piled into the rally, believing this time is truly different. While we will know if this time is indeed different or when a bubble is really a bubble, only after it has passed, a stark difference in the current stock market rally is the widely reviled scepticism among the participants. Put options on the S&P 500 are at a record high but so is the fear of missing out. The Nasdaq has reached all-time-highs and only five stocks in the S&P 500 amount to almost 25% of the Index; there are far more classic bubble signs than there were pre-Covid. Although pre-Covid valuations seemed stretched, the extreme emotional involvement with asset prices leading to a crash and prolonged depressed prices was missing. A common occurrence after each of the above-mentioned bubbles bursting was a subdued price action and the lengthy time taken to reach previous highs. A true bubble causes prices to deflate and remain at low valuations for an extended period of time. Investor psychology plays a big role in creating a bubble. Bubbles are not just caused due to valuation, but also due to an emotional mania. Usually, the peak of a bubble is reached with heightened levels of mania, and there was no such mania in the January highs of equity prices. While share buybacks and a low-interest rate environment helped the stock market rally, individual investors were largely absent and did not significantly contribute to the rally.

To get a better understanding of the current market action, let’s look at past bubbles and price action. They all have certain common characteristics: a clear public involvement and interaction, and prolonged subdued asset prices. When the tech bubble burst in 2000, it took the Nasdaq 15 years to reach its previous highs. The Shanghai Composite Index saw a manufacturing bubble in 2014-15 which burst in 2016; the Index hasn’t seen the previous highs since. After the bubble burst, the PBOC slashed its prime lending rate while injecting liquidity. Nonetheless, the government failed to reflate the market. Both these bubbles saw individual investors demand for equity exposure soar.

Chart Sources: FRED (left) and tradingview (right)

The most dramatic of all was the Japanese asset price bubble in the late 1980s which saw sky high prices for real estate. At one point, the area of the Royal Palace of Japan was valued more than the entire state of California. The bubble popped in 1990 and the equity market has never gotten close to those levels again in the coming 30 years since.

By September 2019, the financial system in the US started to work inefficiently. Many key players were struggling to provide funding and the money markets ceased to function effectively. The Fed then stepped in to provide liquidity and the moves in the S&P correlated with the Fed’s balance sheet. The drivers of the market pre-Covid were thus share buybacks, algorithm-driven market execution trades, and rule-based actively managed funds leveraging the Federal Reserve’s balance sheet. Once Covid hit, we saw a beautiful deleveraging (as said by Ray Dalio) that led to a liquidity crisis which could have turned into a financial crisis. By mid-March, the US Treasury market (arguably the most important financial market in the world) ceased and we saw a 35% sell-off in equity markets. Markets recorded the fastest bear market rally in history as systematic funds tried to de-lever their positions.

Chart Source: FRED

Today’s US stock market rally has seen a dramatic rebound from its March lows, extending it further to reach new highs and disconnect prices from valuations. The historic sell-off was followed by a record-breaking bull-market rally with the S&P 500 posting its best 50-day rally ever. Many companies withdrew their earnings forecast for 2020 while postponing share buybacks. Corporations have tapped into their credit lines, rainy day funds, and are relying on the aid programmes extended by the Fed and Congress. Buybacks will take a long time to return to their previous levels (as also seen after previous crises), but cash-rich tech companies have announced buybacks amounting to $65 billion. These are the same companies driving the Nasdaq 100 to new highs and now amount to a quarter of the S&P 500 Index. The stock market is not the economy and seems increasingly disconnected from the Main Street.

The size of the Federal Reserve quantitative easing programmes in the past 2 months dwarfs their efforts during the crash of 2008. The central bank also announced an unprecedented move – it committed itself to buy individual corporate bonds, something it had never done before. Additionally, the Fed has used its non-conventional monetary policy tool of forward guidance almost every time the market has seen a downtick. All these actions have helped stabilise financial markets and helped equity prices reach new highs. The most important difference between the pre-Covid and post-March lows is the re-emergence of the retail investor. The rally has pulled with itself the involvement of the individual investor community. Retail investors are now attached to the stock market as last seen during the tech bubble and the Great Depression of ’29-’33. Equity volumes have increased to record highs with shares like Hertz, Chesapeake Energy, but also Apple trading with volumes much higher than their average numbers. Retail investors have embraced the notion of ‘buying the dip’ and ‘do not fight the Fed’. All these actions are appearing to create an equity bubble. Buying assets is easier compared to selling them once fear takes over and liquidity ceases.

When the equity market reached record highs in early 2020, it lacked the mania and euphoria needed for a bubble. Predicting how high a bubble can rise is a fool’s errand. The next prices in equities will be determined by the future course of monetary and fiscal action. It will depend on the Fed’s appetite to keep supporting the market and how determined it is to backstop price. How infinite exactly is the Fed’s balance sheet, is the key question. Every mania in the past has seen retail investors play a big role, but we do not know the tenacity of the new breed of individual investors in the current scenario. At some point, psychology takes over rational beliefs. The US equity market is currently a bubble in the making. We probably haven’t seen peak euphoria yet, but the raging battle between the bulls and bears is one of the vital historical signs of a bubble.

By Alpit Kale - King's College London Graduate

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