What causes market bubbles and what causes them to pop?
We feature highlights of a research report that takes a deep historical look at those questions and takes a microscope to large cap technology stocks.
Are they in a bubble and are the conditions ripe for it to burst or not?
Here is an abridged version of a BCA Research report entitled An Investors’ Guide to Stock Market Bubbles.
- With high valuations and deteriorating fundamentals, investors have begun to worry that the market might be in a bubble.
- But what does this mean for investors? Historically, valuations alone are not an effective tool for making allocation decisions.
- We study the past four centuries of financial bubbles in order to help investors diagnose and time the trajectory of future bubbles.
- We found that all the bubbles studied were formed during periods of easy monetary policy and rampant financial innovation.
- We also found that every bubble met its demise shortly after interest rates started rising. Moreover, supply shocks often contribute to bubbles bursting.
- Our findings suggest that while FAANGM stocks might be in a bubble, this bubble is not likely to pop within the next couple of years.
Financial manias are an innate part of markets. Several studies have shown that bubbles occur naturally in experimental markets.
These conclusions hold even when fundamental value is easy to calculate or when participants have training in economics, finance, or business.
The propensity for markets to eventually turn into frenzies has made financial bubbles an inevitable part of the investment experience, and a risk that managers must be conscious of.
Today, this risk has resurfaced. With valuations at nosebleed levels while the economy remains battered by the pandemic, many investors have started to wonder whether stock prices have ran away from fundamentals.
But what exactly does this mean in terms of investment strategy? In this report, we attempt to provide some insights on answering this question.
Specifically, we examine the following issues:
- The value in timing bubbles: Should investors even try to time bubbles? Why can’t they just use a simple valuation framework to avoid frothy markets?
- Similarities between bubbles: Are there any commonalities in the environment surrounding bubbles that can help us diagnose and time them?
- Investment implications: Is there a bubble in FAANGM stocks? If so, how could it pop?
Academic research has revealed that supply shocks often play an important role in the collapse of asset bubbles.
Consider the case of the tech bubble in the 1990s: Between 80% to 85% of the shares of new internet IPOs were held by insiders, venture capitalists, and investors.
These investors were restricted from selling their holdings by lock-up provisions which limited the number of shares potentially available to be sold short, and also prevented better informed insiders from selling and correcting the overvaluation of the stocks’ in question.
However, these restrictions started to ease at the end of 1999.
In the paper “Dotcom Mania: The Rise And Fall Of Internet Stock Prices,” Ofek and Richardson show that as the new millennium approached, tens of billions of dollars’ worth of shares were suddenly removed from their lock-ups (Chart 6, panel 1).
The release of this supply of shares created a sudden and powerful force of selling pressure that ultimately resulted in the demise of the tech bubble.
The investment community has begun to worry about a bubble in the so-called FAANGM stocks.
Since 2018, those six stocks (constituting almost 25% of the market cap of the S&P 500) have returned over 130%, compared to a mere 35% gain for the S&P 500.
Moreover, while the valuations of these stocks are still below 1999 levels, their high multiples have raised some eyebrows, particularly if one considers the current state of the economy (Chart 7).
How should investors approach this group of stocks? Based on the analysis in this report, we can conclude with the following answers:
Is the current market environment a bubble?
Some of the circumstances that have characterized previous bubbles are currently in place.
After a series of rate hikes started to choke off the bull market in 2018, the Fed began to ease rates.
However, this easing took on historical proportions during the COVID crisis, which forced the Fed to grow its balance sheet massively in scale and lower its policy rate to 0%.
What about financial innovation? ETFs and no-commission platforms such as Robinhood have allowed for easier access for new retail investors – a trend that accelerated during the COVID crisis (Chart 8, panel 1).
Moreover, easy market access has also increased leverage: Margin debt – the amount of money an investor can borrow from a broker – has shot to near decade highs (Chart 8, panel 2).
This combination of extremely easy monetary policy, high valuations, and increased leverage and trading caused by financial innovation are signs that mega-cap tech stocks are indeed in a bubble.
Could the bubble pop?
We believe that the circumstances for the bubble to pop are not yet in place, and could in fact take a couple of years to materialize.
Monetary policy is set to remain easy for the foreseeable future, with the market expecting an interest rate hike only in four years’ time (Chart 8, panel 3).
Moreover, monetary authorities are likely to keep credit conditions easy to help the economy recover from the pandemic.
As a result, it is unlikely that we will see hawkishness from the Federal Reserve within the next couple of years, which means that the tech bubble could still have room to run.
What about supply shocks? We do not see many obvious possibilities on the horizon. The one exception could be legislation restricting the ability of companies to buy back their own shares.
Over the past three years, almost 1.1 billion shares have been bought back by the FAANGM companies, keeping a lid on supply, and helping stock prices rise further.
Some Democratic senators have called for restrictions on this practice – an action that could cause a temporary supply/demand imbalance of tech shares in the market.
However, we assign a low probability to such policy, and it is unclear how much such legislation could affect prices.
Thus, with hawkish monetary policy still far away and no supply shock apparent in the near future, the bubble in technology stocks should continue.
Image source: www.lombardiletter.com
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