Pop Stars

Stock markets have hit fresh records this year, and now investors don’t seem to be able to stop worrying about bubbles…

 

🕰 Recap

  • Stock markets have hit record highs this year, but investors are concerned the rally won’t last forever.
  • Those who think inflation will force interest rates higher quickly sold off stocks and bonds earlier this month.
  • So much so, in fact, that the tech-heavy US Nasdaq index collapsed into a “correction”.
  • But that hasn’t stopped a string of tech companies – including Deliveroo and Trustpilot – making their way onto the stock market.

 

✍️ Connecting The Dots

The past year has seen a once-in-a-generation stock market collapse, unprecedented levels of cash in the economy, and a relentless search among investors for growth and yield. And that’s pushed everything from stocks to bitcoin to record highs. To some, it sounds like a recipe for a dotcom bubble-style crash: legendary investor Warren Buffett’s indicator has been showing a stock market disconnected from the real economy for three months, while hedge fund royalty Ray Dalio’s six-part checklist revealed pockets of irrational exuberance too.

And there are signs of a financial market bubble – lots of them: extremely high valuations, frantic investor speculation, low interest rates that have made money cheap and leverage more attractive, a boom in deal-making and stock market listings, and excitement about a new wave of technologies changing the future of the financial system. But what some investors might be overestimating is how big the risks they pose actually are. Investment bank Goldman Sachs, for one, thinks everyone’s blowing them out of proportion.

Just look at US stock valuations: they’re expensive relative to history, but less so relative to record-low interest rates. And while some analysts suggest avoiding American stocks in favor of cheaper European ones, others reckon that you’ll be fine as long as you avoid stocks that are in bubble territory (like “emerging tech”, if Ray Dalio’s to be believed). Likewise, some people point to the FOMO-fueled speculation from retail investors, and it’s true that free trading apps have encouraged a new wave of activity. But in reality, we’ve gone from low retail investor participation in stock markets to less low participation, not high participation. And that isn’t as indicative of a bubble as you might think.

 

🥡 Takeaways

1. Two ways the pros spot bubbles.

Warren Buffett spots a bubble by looking at the ratio of US companies’ market valuations compared to the size of the country’s economy. And when it’s high versus history – like it is now – the Oracle of Omaha gets nervous. Ray Dalio, meanwhile, looks at a few other factors: whether stocks’ current valuations are sensible given future earnings growth expectations, whether there’ve been new buyers entering the market, the sentiment of existing investors, and the amount of leverage being used to make investments.

2. Two ways you can spot bubbles.

One thing you can easily watch out for is a “late-cycle” economic boom: if borrowing money becomes more expensive and economic growth starts to slow, high stock prices (all else equal) become harder to justify and could therefore be in a bubble. Another factor – which is often harder to spot until after the fact – is accounting scandals: a rise in scandals has historically coincided with a stock market bubble, so keep your eyes peeled.

 

🎯 Also On Our Radar

Everyone’s favorite underdog GameStop reported quarterly earnings last week, alongside new plans to beef up its online offering and raise additional money. And with initial data suggesting Americans aren’t spending their latest stimulus checks on stocks like they did last summer, they didn’t come to its rescue this time: its stock dropped by over a third. That’s worth keeping an eye on, since it could signal a return to a more rational market.

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