Stock market bubbles are not as rare as many people think. They occurred throughout history, with multiple generations seeing large swaths of accumulated wealth evaporate in short order. With very few exceptions, the shellshocked investors are left to survey the carnage while trying to discern what happened and why they didn’t see it coming.
There are behavioural explanations for this. They include herding (following the herd), optimism bias (my industry always says the markets will rise), recency bias (where people put too much emphasis on things that are top of mind and current), and confirmation bias (where people simply look for information that supports their own pre-existing views). There are others. It’s as if large swaths of people want to be collectively deluded into thinking the warning signs are not to be believed or – worse still – they simply refuse to acknowledge the signs at all.
If one were to choose a catch phrase for these people, it might be this – “if it feels good, do it.” Investing in a go-go market certainly feels good. Until the day when it doesn’t. Warning people to take shelter before the pending storm is a bit of a fool’s errand, however. When times are good, people like to believe things will stay that way indefinitely.
Irving Fisher was unquestionably one of the greatest American economists of all time, but in the summer of 1929, he opined that markets had reached a state of permanently high elevation. In other words, he recognized the warning signs, but chose to dismiss and/or ignore them. The hallmarks of people getting overly optimistic about future returns were all around him and stories of shoeshine boys providing stock tips were just the tip of the iceberg for irrational investor exuberance. Over ninety years later, little seems to have changed in how people can be duped into what amounts to a form of mass psychosis.
Jeremy Grantham is a Wall Street maven who manages billions of dollars for a firm he co-founded, GMO Capital. When asked where we are now in the market cycle, he suggested we are near a top. Grantham recently said: “Bubbles are unbelievably easy to see; it’s knowing when the bust will come that is trickier. You see it when the markets are on the front pages instead of the financial pages, when the news is full of stories of people getting cheated, when new coins are being created every month. The scale of these things is so much bigger than in 1929 or in 2000.”
I’m just wondering, but has anyone noticed stories about bitcoin or real estate prices or the crazy trading activity in Gamestop? Are those stories consistent with what’s been in the financial press – or do you think they seem a bit disconnected from reality?
The American stock market is in the stratosphere these days and pretty much all the rosy narratives noted about it are based in the United States. There are several metrics that demonstrate this. Warren Buffett’s favourite test is to compare total market capitalization to national GDP. The so-called “Buffett Indicator” now stands at over 200%, which is one of the highest readings of all time. In 1929, it took 22 years for stocks to recover to record highs, so the current reading certainly ought to provide pause, as another massive global downturn seems possible, if not likely. The stakes are enormous.
Economists like NYU’s Nouriel Roubini are voicing concerns that 2021 or some time thereafter could see a rerun of the Great Inflation of the 1970s, while others fear that what lies ahead might be much worse. Traditionally, one of the most reliable indicators of market froth is the Shiller CAPE (Cyclically Adjusted Price Earnings) Ratio, as pioneered by the legendary Robert Shiller. Using a rolling ten-year average and adjusting for inflation, CAPE is widely acknowledged as perhaps the most reliable indicator (no single metric is without false positives) of market excess. Take a look at the CAPE for the U.S. broad market throughout history, as represented by the S&P 500.
The number is now hovering above 38, which is the second highest it has ever been since the number could be reliably calculated, going back over 130 years. Only the ‘dot com’ technology bubble from the turn of the millennium had higher readings. Still, it should be noted that the 1929 crash happened when CAPE was at about 30 and the 2008 global financial crisis crash happened when CAPE was at about 28. Interestingly, it was at a similar level when the market tumbled last spring due to the global COVID pandemic. Indeed, it is helpful to be a student of history when putting today’s markets into context. I cannot help but note that the swift, stark run-up in valuations over the past 17 months or so have been caused almost exclusively by fiscal and monetary stimulus due to COVID.
Now think back to how the economy was doing in early 2020 – before COVID hit. Employment was about as high as it had ever been. Inflation (the hot topic for the summer of 2021) was a benign non-issue. Then, out of nowhere all hell broke loose.
What exactly is better about the economy in late July 2021 as compared to late January 2020? Not much. Both unemployment and inflation are considerably higher than they were then. Citizens are STILL relying on government cheques. Yet somehow, people are borderline euphoric and investors think they are bulletproof. Not because of fundamentals, but because lately they made a lot of money on the markets. In fact, pretty much 100% of the gain in stock prices has been due to multiple expansion (increased valuations), not increased corporate earnings. Investors act as though the recent past is some sort of a reliable prologue of the long-term future. It is not. Throughout history, markets have always gone down after a big run up and gone up after a big drop.
So here is my plea. Be careful. In the past, I have often been asked to offer something prescriptive, but my main advice today is a warning. This could get ugly – maybe uglier than anything you have ever experienced in your life before. If nothing else, stop and ask yourself this question. How would you feel if, a decade from now, markets are lower than today?
I don’t think the next pullback will be of the garden variety (a drop of 10% or 20%). The next pullback will be severe. A global recession or even another depression could easily manifest. By virtually any metric, pretty much all major asset classes are in bubble territory right now and when the bubble bursts there will be few safe havens.
I am trying to warn people, but most seem inclined to ignore me. After all, bearishness is bad for business. My impression is that most people are feeling satisfied and going about their lives without much concern for the things I just laid out.
People seem to be ignoring the warning signs. At a minimum, I would recommend that you:
- Reduce exposure to stocks
- Specifically, reduce exposure to U.S. stocks and growth stocks
- Consider at least a small inflation hedge like gold
- Keep income investments extremely conservative (think money market funds)