In general terms, investment bubbles form when fervent and (sometimes blindly) over-optimistic market speculation pushes the price of the market, an asset class or sector, over and above its intrinsic value.

    So, are we in a bubble? The short answer, nobody knows. Based on historical precedence, and the nature of a bubble, nobody can say for sure until the bubble pops. An array of factors – e.g. the impossibility of defining even an individual securities’ intrinsic value, let alone the market and the unpredictability of human behaviour – make it impossible to define if and when this occurs, or how far past intrinsic value the price must reach before the bubble ‘pops’.

    Although impossible to categorically define if the market is currently in a bubble, I hope to take an objective view of current market conditions and provide insight into the question ‘are we in a bubble?’.

    Historical bubbles

    The term ‘bubble’ in reference to a financial crisis can be traced back to 1720 with the passage of the ‘Bubble act’ by the British parliament, in response to the British South Sea bubble (2).

    This isn’t to say that the South Sea bubble was the first. One of, if not the first recorded bubble was the curiously named ‘Tulipmania’ in 1636-1637 (2).

    Tulips had become something of a status symbol in Western Europe in the late 1500s, with some bulbs found to grow with unpredictable ‘broken’ colours, increasing their rarity and therefore price. However, it was impossible to identify which bulbs would display these traits after they bloomed.

    Speculators began to guess which bulbs would display these traits ahead of blooming season and eventually lost track of rationale, with some prices reaching upwards of the cost of a house.

    There are many other examples of bubbles with the most recent major instances being the dot-com bubble (1995-2001) and the housing bubble (2001-2008).

    Characteristics of a bubble

    Bubbles generally consist of five stages (3); displacement, boom, euphoria, profit-taking and panic.

    Displacement is where investors’ imaginations are captured by a new paradigm. This leads to a boom when prices gather momentum as more investors enter the market.

    When a tweet about a song can increase the share price of the owner’s royalties by over 10% (4), it’s fair to say that in today’s world it’s easier than ever for media to add to and speed up a stock or a market’s momentum.

    Euphoria ensues, with the ‘greater fool’ theory playing out.

    When enough warning signs of an overvaluation are evident the ‘smart money’ takes their profit, which in turn causes panic as investors rush to get their money out, decimating prices.

    Today's market

    Valuations have their drawbacks and context is key, but they’re a useful measuring stick when not used in isolation.

    Known as the Buffett measure, a quick and simple measure to consider is to compare total market cap against GDP. As visualised in figure 1, the ratio is around 175% (compared to the previous high of 131% in 2000) (1). Although a relatively crude measure, this gives a reasonable picture of valuation vs production within a given market.

    Fig 1

    Figure 1: Wilshire 5000 vs US GDP to Jan 2021

    Berkshire are currently sitting on almost $150bl in cash (5) and this might suggest Warren Buffett and Charlie Munger’s views on the market’s current valuation (6).

    Other valuations that point to an overvaluation of the market include global price to sales (7), global stock market p/e ratio (8) and CAPE (cyclically adjusted p/e ratio) (9).

    The shortcomings of valuations

    There’s a multitude of difficulties associated with valuations and things get particularly murky when comparing valuations across different time periods.

    Given the current growth in innovation, accelerated by Covid, companies are more likely to grow at exponential rates in line with this. With current equity valuations based off predicted future earnings, a company trading at 50 times future earnings today shouldn’t be judged on the same playing field as a company that traded at 50 times future earnings in 1970.

    A key difference, as visualised in figure 2 (1), is the historically low bond yields on offer today. If there are unusually low returns on offer in one part of the market – in this case bonds – investors will look to put their money elsewhere – in this case equities. This increased demand will naturally increase valuations.

    Figure 2

    Figure 2: 10-year government bond yields to Jan 2021

    Another differential between past events and today is the economic climate in which they take place. Today’s valuations have been produced during a time of severe economic depression. Covid-19 brought the world to its knees economically (GDP falling 10% in the UK in 2020 (10)), with vast portions of the workforce brought to a complete stand-still for months on end. This required unprecedented government economic intervention and has contributed to the levels of growth being experienced.

    Views on the bubble

    It's also prudent to consider the qualitative opinion of market experts, in conjunction with the quantitative data provided by valuations. Various experts have theorised on the current market situation, with intelligent people on either side of the fence.

    One side of the fence includes Wall Street legends Carl Icahn and Jeremy Grantham. Ichan told CNBC that in the market’s rush to get everything back to normal, post-Covid the value of certain stocks are being wildly overestimated, with a correction all but inevitable (11). Grantham’s warning was a little more pointed, stating that “the long, long bull market since 2009 has finally matured into a full-fledged, epic bubble” (11).

    On the other side of the fence, Goldman Sachs strategists argue that despite high pe ratios, other evidence – namely low interest rates and a lack of non-government leverage – indicate there is no bubble, with chief strategist Peter Oppenheimer telling Bloomberg Television “Given the level of real rates where they are, it’s still likely to be broadly supportive for equities versus bonds” (9).

    It's about time in the market, not timing the market

    Timing the market is notoriously difficult (if even possible) and studies show that you’re better off remaining invested and riding out any dips than attempting to forecast when the bubble will pop (12, 13). In fact, as figure 3 (1), indicates, over one and five year holding periods, you’re actually better off buying and holding on days of a record high than buying and holding on every day the market was open.

    Figure 3

    Figure 3: S&P 500 rolling periods from 01/01/1970 - 06/04/2020

    Human nature will always allow bubbles to flourish. If you see your friend, family member or neighbour making a fortune on the latest craze, natural instinct is to take advantage of it yourself. There's no way of predetermining if the market is in a bubble and although it is useful to reflect on current market conditions it should not alter your long-term view of the market.

    Investment decisions should be almost solely based on your individual client investment goals. What returns are required and what potential risk associated with investing for that return is acceptable?

    References

    1. Morningstar Direct
    2. A Brief History of Financial Bubbles | Stanford Graduate School of Business
    3. 5 Stages of a Bubble (investopedia.com)
    4. 'Baby Shark' Investor Jumps After Elon Musk Tweets on Viral Song - Bloomberg
    5. Warren Buffett's Berkshire Hathaway (BRK/A) Results: Latest News on Cash Pile - Bloomberg
    6. Charlie Munger Has a Warning for Investors | The Motley Fool
    7. Global Payments Price to Sales Ratio 2006-2021 | GPN | MacroTrends
    8. Global Stock Market P/E Ratio & Valuation | Siblis Research
    9. Bubble Deniers Abound to Dismiss Valuation Metrics - Bloomberg
    10. Coronavirus and the impact on output in the UK economy - Office for National Statistics (ons.gov.uk)
    11. 5 Billionaire Investors on the Soaring Stock Market | Money
    12. Why you shouldn't try to time the top of the market - Wealth management - Schroders
    13. https://realreturns.blog/2020/11/12/advice-for-investing-at-all-time-highs/