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Are we in market bubble territory?
In his 1841 book ‘Extraordinary Popular Delusions and the Madness of Crowds’, Charles Mackay describes the history of bubbles, from the 17th-century Tulip Craze in the Netherlands to the 18th-century South Sea Bubble in England. He didn’t know about the market bubbles that would come later: railways in the 19th century, radio in the 1920s, the dotcom bubble, subprime mortgages and so on.
Essentially, the concept of a bubble is an exaggerated fear of an overbought market in any asset class. Logically, if people are talking about bubbles all the time, chances are there is no bubble. The 17th-century Dutch merchants never thought tulips were in a bubble. That’s why there was one.
Why some commentators believe we might be experiencing market bubbles at the moment
At the time of writing, there is a lot of cash in the economy, due to money supply, fiscal spending and savings during the pandemic. As markets continue their rise, some commentators have pointed to signs of excess, even going so far as to suggest we are entering bubble territory. They point to:
- Huge upward movements in bitcoin and other cryptocurrencies
- The increasing number of ‘Special Purpose Acquisition Companies’ (companies set up and floated on markets with the express purpose of acquiring other companies)
- The proliferation of takeovers and initial public offerings (IPOs)
- The extraordinary gyrations in previously very unpopular and heavily shorted companies such as GameStop in the US, based on recommendations on internet forums
- Heady valuations in popular technology companies
- Huge rises in many ESG (environmental, social, governance) related themes
- The apparently exponential growth of Tesla stock and the fact that its CEO, the visionary Elon Musk, is now one of the world’s richest men, with a paper value that recently touched US$200bn (speculation has it that he will be the world’s first trillionaire).
Which assets might be in a bubble now?
Cryptocurrencies come to mind. The use of blockchain for cryptocurrencies is uncontrolled, unregulated, dominated by a small number of founders, subject to complicated induction rules and inherently vulnerable to security breaches, with many instances of bitcoin having been lost or stolen. There are also no valuation metrics to rely on, so blockchain is impossible for investors to value.
The risk for cryptocurrency investors is that it could simply be regulated away. In the UK, the Financial Conduct Authority (FCA) is stopping retail investors from buying cryptocurrencies; India is planning to ban them. China is launching a digital currency controlled by its own central bank; the US Federal Reserve is researching a similar idea.
Given how much illegal money (the proceeds of crime, tax evasion and anonymous money) is lodged in cryptocurrencies, there is probably a point where governments will get involved, stop the anonymity, and start taxing gains, transactions or wealth to prevent damage to the economy.
Will cryptocurrencies then be brought into the mainstream by institutional investors, packaged so that retail investors can buy them? Can anything keep rising at this rate without imploding? At what point is it a tulip? As an investor, should you get involved unless you can afford to lose everything?
Are there other potential bubbles in the broader equity market?
It is possible that people diagnosing bubbles right now may be older investors who have not kept up with the evolution of the economy and markets. They want markets to go back to where they were 30-40 years ago, so they can find a winning strategy again. Equity valuations may also be affected by two factors:
- Analysts are not good at valuing shares of companies that grow very fast
- In these fast-growth businesses, some companies succeed beyond expectations and others go bankrupt; the whole point is picking the right ones rather than haggling over their share price.
Interestingly, the main market concern about the five or six largest and most expensive US stocks has partly been dealt with by the market, since they have fallen compared to other sectors and shares. Markets are providing a self-correcting mechanism for high stock valuations.
What is interesting amid investors’ comments is how many people think we are coming close to the end of an economic cycle which has only just begun. Yet fiscal and monetary authorities are trying to make sure that this cycle goes on for a very long time so that unemployment goes down to its previous lows. If there is a bubble, it’s in bubble forecasts!
It is incongruous that many investors believe the whole stock market is in a bubble when governments and central banks are throwing vast amounts of money at the economy, individuals are sitting on all-time-high savings and household net worth, companies’ debt service costs are at historic lows and the labour market is starting to heal. This is not the textbook definition of a bubble, except maybe in some very specific corners of the markets.
How can investors protect themselves from potential market bubbles?
Diversified portfolios tend to combine cheap and expensive assets, with the cheap ones expected to rebound with economic growth and the expensive ones continuing to perform when global growth recedes. The relative ratio of these investments can move tactically and is designed to achieve the right mix of upside potential and downside protection.
Valuations and money flows are just two of the factors we scrutinise daily to make sure that none of our discretionary portfolio investments is about to meet that fate. This behaviour came in handy during the COVID-19 pandemic as we scrutinised every single investment to make sure it could survive the lockdowns.
Are we in bubble territory now?
Minuscule interest rates, rebounding economies, a consumer primed to spend: at the moment, for equities, it really is a case of TINA (there is no alternative). Normally at times like this, the role of central banks is to take away the punch bowl just as the party is getting started. But with the shock of COVID-19, the worst ever pandemic faced by world economies in the modern era, those bankers are in no hurry to end the cycle now.
So, pockets of irrationality? Yes. Bubble? No.
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 As Tesla's Market Cap Crosses $800 Billion, Musk's Wealth Zooms Past US$200 Billion - https://www.goodreturns.in/news/as-tesla-s-market-cap-crosses-800-billion-musk-s-wealth-zooms-past-200-billion-1196937.html?story=1
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Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.
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