Recognizing bubbles
Are we in one?
First, housekeeping - the survey results will be out as always on Tuesday, while calling everyone to participate again next week. You can already tell from our predictions published on Thursday that the results are good.
Second, we will, as promised, keep you informed about the markets with long but interesting weekend reads. This is the first in a long line of such articles, delivered every other Sunday. Also, these long educational reads will be presented via a thread on Twitter.
There has been ample talk about an upcoming market crash ever since, well, the previous crash, in addition to continuing discussions on market irrationality and historically high valuations. A typical indicator people like to point out is Shiller’s CAPE ratio, which is at its second highest ever value (around 38 multiple).
Is there anything we can use to tell whether a market is indeed in a bubble? What does being overvalued even mean? To borrow a quote from the movie The Big Short:
Lawrence Fields: “Actually, no one can see a bubble... that's what makes it a bubble.”
Michael Burry: “That's dumb, Lawrence. There are always markers.”
Burry says all signs are again pointing to a huge bubble and the “mother of all crashes”. Should we just take his word for it? Or are there some other things we can look to (besides charts and rule-of-thumb indicators)?
A good idea would be to remind ourselves what the top authority on market irrationality and exuberance has to say about it - Nobel prize winner Robert Shiller. Specifically, to revisit the lessons of his most influential book Irrational Exuberance, where he successfully anticipated both the dot-com bubble in 2000 (first edition), and the housing bubble in 2006 (second edition).
Time for a long and interesting weekend read. Let’s dive right in.
Structural factors
We start with structural factors. Shiller cites 12 precipitating factors, long-term trends that have made contemporary markets in general more prone to asset price bubbles (US-centric, but most trends are present in Europe as well):
The rise of capitalism and the ownership society (private property became the main method of savings, which consequentially placed more focus on rising housing prices; plus trends of downsizing and lower job security made people more focused on entrepreneurial and speculative opportunities – you are loyal to yourself not the company you work for)
Cultural and political changes favoring business success (encouraging the mentality to hold stocks, not sell them, in order to reap long-term gains from the market)
Rise of information technology (encouraging striking valuations of new tech companies)
Supportive monetary policy and the “Greenspan put” (the idea that the Fed is so good for the markets that in itself it represents a put option to protect from market shocks)
Boomer generation impact on markets (they were the key demographics that started investing and saving up for retirement, which encourages boom cycles)
Business media news reporting (daily non-stop coverage of markets which builds into the narrative of looking for stock tips)
Optimistic forecasts of analysts (analysts support the sales branches of their firms, and they have a disincentive to publish negative reports about their own clients – the result is an inflation of good ratings given to all companies)
In today’s market this is mirrored by the disincentive to announce short positions, which was particularly exposed during the GameStop (and in general meme stock) exuberance in January and February 2021.Expansion of contribution pension plans (the 401(k) accounts in the US) (they encourage people to put more money into stocks, bonds or mutual funds, which significantly impacts stock market activity)
The growth of mutual funds (as a consequence of the pension plans)
Decline of inflation (linked closely with the long-term trend of lower and lower bond yields, which obviously encourages stock investment; plus low inflation environments are, to investors, strong signals of a good and prosperous economy)
Expansion of the volume of trade: discount brokers, day traders, algo trading (brought by very low barriers to entry for new investors in terms of lower, almost negligent brokerage fees)
Rise of gambling opportunities (stock markets treated like a casino with winners and losers)
Shiller wrote about these in 2000 for the first time. How many of these structural factors do we see materializing today? All of them actually. Some of these structural factors are merely long-term trends - capitalism and the ownership society, cultural changes, mutual funds and 401(k)s - but others are arguably even more amplified today. Monetary policy has been aggressively accommodative to markets, particularly in light of the previous two stock market slumps (in 2008 and in 2020). The ‘Greenspan put’ is now called the ‘Fed put’, bond yields are continuing their historical decline, as was inflation prior to the COVID demand shock, while information technology today is much more advanced than 20 years ago when Shiller predicted its dot-com bust. The final two factors – the ease of access to investing and the rise of gambling opportunities – are best exemplified by the new social media apps and new brokerages (like Robinhood) that gamified investing and significantly increased the volume of trading.
Basically, all of these structural factors are here today, even more amplified compared to 20 or 10 years ago, just before the dot-com and the housing bubbles. In fact, prices of housing went over their 2006 peak (when they increased 100% compared to a decade earlier).
Amplification mechanisms and other factors
Shiller also talks about amplification mechanisms that work to create a sort of a feedback loop where investor confidence is increased because of past price increases, who then, out of fear of missing out (FOMO), bid up prices even higher, which encourages even more investors to jump in and benefit from the rise in prices. When people notice stock markets constantly breaking new records (an amplification mechanism induced by non-stop media coverage; part of Shiller’s cultural factors), they naturally want to get in on the action. However, jumping in at a time of overinflated market values is likely to be too little, too late. In that case, Shiller paints the bubbles as naturally occurring Ponzi schemes – they enrich those who were lucky enough to be in early (at the top of the pyramid) and who got out in time, but when it breaks up all it has left are bag-holders – those who lost it all after investing at the height of the bubble.
The media is important here as it is a good way of gauging sentiment in terms of demand for news. The news media often, in my option, gets slammed by its sensationalistic bias and scare stories that work as click-bait articles. However, the media is merely responding to an active demand for that type of news. If sensationalism drives clicks and views, it also drives revenues. So the media has an incentive to deliver stories that people will read. And if a lot of people want to read more on markets and investing, that too is a sign of a feedback loop that builds itself into rising market prices and fuels the bubble.
Other factors that characterize a bubble are new era economic thinking, or what I like to call the “this time is different narrative”. Shiller cites a multitude of narratives from previous stock market booms that are almost comically identical as the current narratives being thrown out. For example, narratives like today’s high valuations being justified because the world has changed, or that new technology warrants the high valuations because of future expected benefits, or that globalization and the Internet make things better today meaning that the new era will make everyone rich, and so on. There is no doubt that societies do enter new eras every once in a while. The 1920s were a new era, as were the 1950s and 1960s, the 1980s and 1990s, and of course the current post-08 bubble that lasts until today, with a brief COVID episode that interrupted the longest historical bull market.
Finally, and most importantly are the psychological factors, ranging from various anchors of market performance or asset prices that we bestow upon ourselves (e.g. I will not sell this stock until it reaches $X price, or I value my house at $X+N, because I bought at for $X 10 years ago when prices were lower). In these cases the stories people tell each other about the stock or the value of an asset is what really drives all the psychological anchors that we place on our intrinsic valuations.
Then, of course, there is a host of other physiological factors like overconfidence in one’s abilities to time the market, survivorship bias when looking only at a limited pool of past successes, massive hindsight bias of knowing exactly what you should have done, and the effect of herd behavior and epidemics particularly amplified by social media where retail investors talk and join in on a massive scale to buy into a stock. Again, the meme stock trends of 2021 are the best example, but so is the exuberance surrounding the TSLA stock that started back in 2016 (before the company had even reached profitability and was behind on its new car orders), and really shot up in 2020. The TSLA exuberance is a great example of both the new era narrative (buying now in expectation that the company will be a market leader in the future; a combo of a tech giant and the biggest car company), FOMO, price anchoring, media attention, and an obvious positive feedback loop. Another narrative bubble (one that Shiller devotes a lot of attention to in his newest book “Narrative Economics”) is the Bitcoin (and cryptocurrency) narrative. It has all the same characteristics.
What to do?
Having known all this, are we, then, in a bubble? Yes. Most definitely. Just by looking at the Shiller CAPE ratio, or by thinking about all the aforementioned factors this becomes obvious. Does this mean we can predict when it will burst? Not a chance.
So what can we do? First, design your investing strategy so that if you are in the market, you do not lose out too much from a 5-10% correction (like the entire month of September 2021 when equities went down for the first time since March last year). Second, follow the bond market for signals of when the Fed will no longer be so accommodative and in that time hold more cash than stocks, in anticipation of buying the (actual) dip when the market enters into a more serious correction and the bubble is finally exhausted. Don’t fool yourself in predicting when exactly this will happen.
If you really want to do some predictions, stick to our weekly surveys and look out for predictable short-term weekly signals. No, we won’t predict the bubble burst either, just help you navigate through it.
Thanks for reading, hope you enjoyed it!