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5 Signs That We’re in a Stock Market Bubble (and what you can do about it)

5 Minute Read

19 March 2021

By Alex Hamilton

Introduction

The stock market today is abnormal. Speculative trading, mania, and unhealthy economic policies have led to a market which is valued at concerningly high levels. Here, we investigate the evidence, the potential causes for such a situation and, how to mitigate the risk with Aikido Strategies.

1. Observations of Mania

How many advertisements for stock trading apps have you seen recently? How often do you hear of the stock market in the media?. Smartphone trading is increasing. Large online brokers report that over 20% of retail investors annual trades were carried out on a smartphone device. The ability to trade via smartphone results in the ability to trade instantaneously in any environment. This can result in increased impulsive, gambling-type behaviour in the market. Furthermore, the ability to trade also leads to daily fluctuations in emotional states having a greater impact on one’s investing decision. Concerningly, it has been found that smartphone trading increased the probability of purchasing lottery type assets by 67% of the unconditional mean.[1]

In short, smartphone usage has increased speculative trading in the market. I explored this further by installing and investigating some of the big investing apps, which will remain nameless for obvious reasons. I noticed that all of these apps appear to encourage more risky styles of trading such as, increased leverage via contracts for difference (CFD’s) and some, giving the ability to trade in options. Such investment products may pray on the less experienced investor and, open such individuals up to high volatility and loss of capital through forced margin calls. Indeed, a sizable uptick in the trading of options has been observed. Equity option trading is 50% above last year’s levels year to date. This has been attributed to the pandemic resulting in an inflow of new inexperienced speculators using stocks to satisfy gambling cravings previously satisfied through sports betting and casino games.[2]

Such an observation provides an explanation for the more impulsive behaviour witnessed on these platforms. However, more importantly, it shows a sign of the times, reminiscent of the levered, speculative trading that caused the crash of 1929.

Other signs of mania can be seen in the volatile swings of individual stocks and commodities. Examples being, Tesla, Gamestop and, the Cryptocurrency market. Tesla is a prime example of such risky speculation. It is a company that makes visionary products, has a great mind and leader in Elon musk. However, It’s price astronomically high due to it’s cult following. As Benjamin Graham stated ‘a great company is not a great investment if you pay too much for the stock’. An ominous warning from the past is that of Sun Microsystems. From 1995-1999 Sun’s earnings per share (EPS) had tripled. This growth attracted the speculators. Between ’98 and ’99 its EPS had increased 24%. In the same timeframe, It’s share price had increased 234%. At the end of ’99 Sun share price was 309.75$. In 2001 its share price was 12.3$. Sun Microsystems was a great company, with great leadership and, promising products but, greed and speculation in the market destroyed it.[3] Tesla’s PE ratio is 867.36 as of 05/03/2021.[4] Its share price has shot up 341% during a global pandemic. It is impossible for such a company to grow at a rate that can consolidate such a valuation. More importantly, it shows the amount of naïve money that is currently circulating in the market today.

2. A Look at The Market’s Fundamentals

Price to Earnings Ratio

The S&P500 has a price to earnings (pe) ratio (ttm) of 41.54 as of 05/03/2021, a year ago it was 22.75. Both values have deviated concerningly far from the mean of 15.89.[5]

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S&P500 PE Ratio

Figure 1. Price to Earnings ratio for the S&P500 index over time with periods of economic recession highlighted in grey.[5]

Schiller PE ratio

This ratio is determined by dividing price by the inflation-adjusted 10 year moving average for earnings. As of 05/03/2021 the Schiller pe ratio for the S&P500 was 33.74 that’s higher than the value observed before the financial crisis of ‘08 and a considerable deviation from the mean of 16.79.[5]

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S&P 500 Shiller PE

Figure 2. Schiller PE ratio for the S&P500 with respect to time, periods of economic recession are highlighted in grey. [5]

Graham fair value

Plotting a graph of the S&P500 price vs its GF fair value you can see a troubling deviation both pre and post pandemic. This indicates that the market is overvalued compared to historical valuations.

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S&P 500 Graham fair value

Figure 3. Graham fair value for the S&P500 index from 2014 to 2021.[5]

The Buffet indicator

The buffet indicator is based on the historical ratio of total market cap over GDP. Currently this value sits at 184%. Further indicating that the market is significantly overvalued.[6]

GDP – based recession indicator index

The index corresponds to the probability of the current economic situation is one of recession based on the available data. The index is based solely on currently available GDP data and is reported every quarter. Due to the possibility of data revisions and the challenges in accurately identifying the business cycle phase, the index is calculated for the quarter just preceding the most recently available GDP numbers. If the value of the index rises above 67% that is a historically reliable indicator that the economy has entered a recession.[7], [8]

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S&P 500 recession indicator

Figure 4. GDP – based recession Indicator Index % with periods of economic recession highlighted in grey.[7]

 

3. Economic policies

During the dotcom crash the Federal reserve engaged in quantitative easing to battle the market selloff. This was reasonable to restore faith in the markets. However, interest rates never recovered to their original levels. Coupled with these low rates, the Bush administration practiced a dualistic economic policy, preaching free market capitalism whilst also guaranteeing mortgage loans. Government guarantees, and low interest rates led to irresponsible lending practices, which was in a way responding to the unmeetable demand for mortgage-backed securities. The government encouraged greed and speculation in the market. When it all came crashing down this drove the Fed to repeat the actions carried out in response to the dotcom bubble. This was necessary, the resulting sell off had to be backstopped otherwise another depression would be the result. However, there has been no restoration of interest rates or the Fed’s balance sheet. Today, Interest rates are at near zero with 7.5 trillion is on the fed’s balance sheet both these values are record breaking for the U.S. The only viable option for stimulus that remains is to print money. In short, Fed stimulus in response to the dotcom bubble did not cause the ‘08 financial crisis but encouraged bubble formation through market complacency which has encouraged speculative behaviour. The same has happened today. The difference is that the Fed has used up the standard tools to stimulate the economy. Now, the reality is that the fed can only print money as a means of stimulus. Indeed, this has been the case. 23% of all U.S. dollars created were created last year in the extreme stimulus policies pushed by the Trump administration and Fed chairman Powell in response to the pandemic.[9], [10], [11]

FED inflation

FED inflation

Figure 5. M2 money stock with respect to time periods of recession are highlighted in grey.[11]

It does not take much searching to find out where money printing goes. Notable examples being that of the Weimar republic and Zimbabwe. Injecting new money into the market will of course lead to an increase in stock prices but, such prices are smoke and mirrors. There is no increase in value just the amount of currency needed to purchase the common stock. Inflation is not instant. There will be a refractory period between the injection of cash and the devaluing of the dollar. Right now, the market is still high from the stimulant. The crash will come later and, when it does, it will be very ugly, particularly due to the number of impulsive speculators present as discussed above.

FED interest rates

FED interest rates

Figure 6. federal reserve interest rates with respect to time. [12]

Total Assets of the Federal Reserve

Total Assets of the Federal Reserve

Figure 7. Assets of the Federal Reserve with respect to time.[13]

 

4. ‘Blind Money’ In The Market

An exchange traded fund (ETF) is a type of security that involves a collection of securities such as stocks that are packaged into an underlying index. ETF’s are a popular choice for individual investors who may want to invest but, lack the knowledge, time or experience to engage in picking individual stocks. There is a sentiment that due to their diversification and defined criteria in which their assets are selected that ETFs are low risk. As such, they have become a popular investment choice. It is the opinion of this author that this is not the case. These passive investments now account for approximately half of the entire stock market, as more investors are pivoting to ETF index funds. This has resulted in a sizable amount of money invested into the stock market in absence of any security analysis of the common stock which is being purchased. Consequentially, many companies are overvalued as a result such blind money investments.

 

5. Other Concerning Observations

The Wealth Gap

One aspect of the economic cycle are fluctuations in wealth inequality. At the late stage of a market cycle, wealth inequality tends to increase. As of late, wealth inequality has been on the rise in the U.S. Affluent families have added to their wealth, whereas the bottom has dipped into negative wealth. During the late 1920s, the share of wealth held by America’s wealthiest had peaked. This share halved over the next 30 years following the great depression. Today, wealth inequality is comparable to where it was in the late 1920’s. The bulk of this wealth resides in the stock market. America’s top 1 percent holds more than half the national wealth invested in stocks and mutual funds. Most of the wealth of Americans in the bottom 90 percent comes from their homes, the asset category that took the biggest hit during the Great Recession.[14], [15]

The top 5% of Americans own Two-Thirds of the Wealth

The top 5% of Americans own Two-Thirds of the Wealth

Figure 8 wealth inequality in the U.S. with respect to time.[15]

Many economists now believe that rising income inequality can contribute to slow growth. Howard Sherman and Paul Sherman argue that, though little noticed, inequality rises during cyclical upturns. The lack of income in turn sows the seeds of the next recession.

Student Debt

Student debt has tripled since 2004 and, is second only to mortgage debt in the U.S. Furthermore, College costs have outpaced the consumer price index by a factor of 4 since 1985. This has had an inhibitory effect on homeownership, starting a family, and most importantly, saving for retirement.

The baby boomer generation is now entering retirement age thus, many will be cashing in on their pensions. Retirement account investments were estimated to hold 37 percent of the total U.S stock market cap. Millennials, being crippled by low wages and high debt makes it reasonable to assume that this will result in a large outflow from the market which will not be restored for quite some time. [16], [17]

USA Student debt as a share of GDP

USA Student debt as a share of GDP

Figure 8. U.S. student loan debt with respect to time.[18]

Mitigating The Risk

Bubbles are a normal part of the stock market. Bubbles come and bubbles burst. Prediction of when and, how that will happen is something very difficult if not impossible to achieve. However, being aware of the common signs of a bubble is an essential factor in protecting your wealth.

As discussed, evidence strongly points to the stock market being overvalued. The higher a stock is priced the greater the selloff. As such, the advisable approach would be to transition to value stocks, with a greater margin of safety and lower debt. Aikido’s magic strategy and robust, efficient and undervalued strategies would be a good place to look for such companies. Other options could be in commodities such as gold or silver.

References

  1. Kalda, A., Loos, B., Previtero, A., & Hackethal, A. (2021). Smart(phone) investing? A within investor-time analysis of new technologies and trading behavior. doi:10.3386/w28363

  2. BobPisani. (2020, December 04). Pandemic-induced options trading craze shows no signs of slowing down. Retrieved March 12, 2021, from https://www.cnbc.com/2020/12/04/pandemic-induced-options-trading-craze-shows-no- signs-of-slowing-down.html

  3. Graham, B. (2003). The Intelligent Investor. New York, New York: HarperCollins.

  4. https://uk.finance.yahoo.com/quote/TSLA?p=TSLA&.tsrc=fin-srch

  1. Economic indicators. (n.d.). Retrieved March 12, 2021, from https://www.gurufocus.com/economic_indicators/63/sp-500-index

  2. Buffett indicator: Where are we with Market Valuations? (n.d.). Retrieved March 12, 2021, from https://www.gurufocus.com/stock-market-valuations.php

  3. Economic indicators. (n.d.). Retrieved March 12, 2021, from https://www.gurufocus.com/economic_indicators/962/nominal-median-personal- income-in-the-united-states#1346

  4. Hamilton, J. D. (n.d.). The Econbrowser Recession Indicator Index. Retrieved March 12, 2021, from http://econbrowser.com/recession-index

  5. The federal reserve is the cause of the bubble in everything. (2020, January 16). Retrieved March 12, 2021, from https://www.ft.com/content/bc83fda6-3702-11ea-a6d3- 9a26f8c3cba4

  6. Gjerstad, S., & Smith, V. (2009, April 06). From bubble to depression? Retrieved March 12, 2021, from https://www.wsj.com/articles/SB123897612802791281
  7. Mish. (2020, October 15). 23.6% of all US dollars were created in the last year. Retrieved March 12, 2021, from https://www.thestreet.com/mishtalk/economics/23-6- of-all-us-dollars-were-created-in-the-last-year
  8. United States Fed Funds rate1971-2021 Data: 2022-2023 Forecast: Calendar. (n.d.). Retrieved March 12, 2021, from https://tradingeconomics.com/united-states/interest- rate
  9. Board of governors of the Federal reserve system. (n.d.). Retrieved March 12, 2021, from https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
  10. Wolff, E. (2017). Household wealth trends in the United STATES, 1962 to 2016: Has middle class Wealth Recovered? doi:10.3386/w24085
  11. Wealth inequality. (2021, March 03). Retrieved March 12, 2021, from https://inequality.org/facts/wealth-inequality/
  12. Oct 22, 2. (n.d.). Will a student loan debt crisis sink the u.s. economy? Retrieved March 12, 2021, from https://knowledge.wharton.upenn.edu/article/student-loan-debt-crisis/
  13. Only about one-quarter of corporate stock is owned by TAXABLE SHAREHOLDERS. (2016, May 16). Retrieved March 12, 2021, from https://www.taxpolicycenter.org/taxvox/only-about-one-quarter-corporate-stock-owned- taxable-shareholders
  14. Ingraham, C. (2019, June 25). Analysis | 7 ways $1.6 trillion in student loan debt affects the U.S. economy. Retrieved March 12, 2021, from https://www.washingtonpost.com/business/2019/06/25/heres-what-trillion-student-loan- debt-is-doing-us-economy/