I like to convert my intuitive thinking into indicators which I write down as decision rules (principles) that can be back-tested and automated to put together with other principles and bets created the same way to make up a portfolio of alpha bets. I have one of these for bubbles. Having been through many bubbles over my 50+ years of investing, about 10 years ago I described what in my mind makes a bubble and use that to identify them in markets—all markets, not just stocks.
Combination of six factors
I define a bubble market as one that has a combination of the following in high degrees:
high prices relative to traditional measures of value (by taking the present value of their cash flows for the duration of the asset and comparing it with their interest rates);
unsustainable conditions (extrapolating past revenue and earnings growth rates late in the cycle when capacity limits mean that that growth can’t be sustained);
many new and naïve buyers who were attracted in because the market has gone up a lot so it’s perceived as a hot market;
broad bullish sentiment;
high percentage of purchases being financed by debt;
a lot of forward and speculative purchases made to bet on price gains (inventories that are more than needed, contracted forward purchases).
I apply these criteria to all markets to see if they’re in bubbles. I have periodically shown you these for stocks and the stock market.
Back to reality
I will first describe in words and then will show in charts the picture and how it has changed since January, when I last shared an update of the bubble indicator.
In January the bubble indicator showed that a) the US equity market as a whole was at the edge of a bubble but not in an extreme bubble (70% of the way toward the highest bubble, which happened in late 1990s and late 1920s) and b) the emerging tech companies (e.g., Tesla and Roku) were clearly in an extreme bubble. I also noted that other bubbly behavior (SPACs, the IPO boom, the big pickup in options activity) financed by the unprecedented flood of liquidity post-Covid had found its way into the asset markets, making things bubbly. I showed which stocks were in bubbles and created an index of those stocks, which I call “bubble stocks.”
Bubbles can take a long time to unwind (two years in the case of the 1929 bubble, one year in the case of the late ’90s tech bubble) and typically go to the opposite extreme, so just because they aren’t at a bubble extreme doesn’t mean they are safe or that it’s a good time to get long. In fact, US stocks in aggregate still look overvalued by our measures. History shows that once the popping begins, bubbles more often overcorrect to the downside versus settling at more “normal” prices.
The chart below shows the bubble gauge for the average of the most bubbly companies as defined in 2020. Readings for those companies are meaningfully down.
A comparison with past crises
Everything we’re seeing driving the bubbles in this segment of the market is classic—virtually the same drivers we saw 100 years ago in the 1920s and a little over 20 years ago in the 1990s bubble. For instance, in the last couple months, it was how tightening can act to prick the bubble. To understand these dynamics, you might want to review this case study of the 1920s stock bubble (starting on page 49), from my book Principles for Navigating Big Debt Crises.
The following charts walk through each of the pieces of the bubble gauge for the US stock market as a whole. While I won’t show you exactly how this indicator is constructed because that is proprietary, I will show you some of the sub-aggregate readings and some indicators.
Each of these six influences is measured using a number of stats that are combined into gauges. In the stock market, this approach is applied each stock that I’m looking at. These gauges are combined into aggregate indices by security and then for the market as a whole. The table below shows the current readings of each of these gauges for the US equity market. It shows how the conditions stack up today for US equities in relation to past times. These readings suggest that we’re out of a bubble.
The worst is behind us
- How High Are Prices Relative to Traditional Measures? The current read on this price gauge for US equities is around the 50th percentile.
- Are Prices Discounting Unsustainable Conditions? This measure calculates the earnings growth rate that is required to produce equity returns in excess of bond returns. This is derived by looking at individual securities and adding up their readings. Currently, this indicator is just around the 60th percentile for the aggregate market—more elevated than some of our other readings.The earnings growth discounted in stocks is still a bit high.
This is even more noticeable in the US software sector. Analyst earnings growth expectations for this sector have come down, but they are still relatively high compared to history. P/Es have reversed their COVID gains, but remain high compared to history.
- How Many New Buyers (Those Who Weren’t Previously in the Market) Have Entered the Market?
A rush of new entrants attracted by rising prices is often indicative of a bubble. This was the case in the 1990s equity bubble and in the 1929 bubble, based on accounts of the time (though, regrettably, our data doesn’t go back that far for this gauge and some of the gauges we’ll show next). This gauge shot above the 90th percentile in 2020 due to the flood of new retail investors into the most popular stocks, which by other measures appeared to be in a bubble. More recently, we have seen meaningful moderation in the pace of retail activity in the markets—it’s now back around pre-COVID averages.
- How Broadly Bullish Is Sentiment?
The more bullish the sentiment, the more people have already invested, so they are likely to have fewer resources to keep investing and are more likely to sell. Sentiment in the market is now significantly negative.
- Are Purchases Being Financed by High Leverage?
Leveraged purchases make the underpinnings of the buying weaker and more vulnerable to forced selling in a downturn. The leverage gauge, which looks at the leverage dynamics across all the key players and treats option positions as a form of leverage, is now showing a read around the 50th percentile.
- To What Extent Have Buyers Made Exceptionally Extended Forward Purchases?
One perspective on whether expectations have become overly optimistic comes from looking at forward purchases. I apply this gauge to all markets and find it particularly helpful in commodity and real estate markets, where forward purchases are most clear. In the equity markets, I look at indicators like capital expenditure—whether businesses (and, to a lesser extent, the government) are investing a lot or a little in infrastructure and factories.
What one chooses to do with this is a tactical decision. While the reversal has been significant, discounting of future earnings remains somewhat high compared to history. And either way, bubbles more often overcorrect (sell off more than the fundamentals would suggest) versus just settling back to normal levels. But I wanted to pass along these updated readings to you in light of what’s now going on in the markets.