January 5, 2021

Ticking The Boxes On The Stock Market Bubble Checklist

Dizzying Valuations, IPO Craze Tick Boxes on Bubble Checklist

Adapted from sourced Bloomberg articles at the bottom of this page

The stock market was on fire in 2020, with the Dow Jones Industrial Average poised to end the year above 30,000, a record. Meanwhile, 30,000 people in the U.S. died of the coronavirus in just the past two weeks, and the estimated number of American adults who don’t have enough to eat has risen to some 27 million.

Shares of smaller public companies have caught up to the blue chips lately, with the Russell 2000 Index up almost 17% so far this year. Meanwhile, the number of small businesses operating in the U.S. has plunged 25%, according to a Harvard tracker.

Somehow the theme of the year became ignoring all of the chaos and suffering of this dystopian present and skipping right ahead to a utopian future. There were some good reasons to do so; for those of us holding jobs, many outlets for discretionary spending were shut down, while savings swelled. Much of that spare cash likely flowed into the stock market, whether via Robinhood traders chasing story stocks or more conservative investors seeking diversification. Investors poured $29.4 billion into U.S. equity funds in the week through Dec. 15, the fifth-biggest weekly inflow ever, according to EPFR Global. Exchange-traded funds tracking equities pulled in $46 billion in December after luring $81 billion a month earlier. The rest of those savings, the thinking goes, will stream back into the economy via consumer spending when the threat of the virus recedes.

You may also have noticed that the IPO market is manic. Stocks haven’t been this expensive since the dot-com era. The Nasdaq 100 has doubled in two years, while volatility remains stubbornly high. It’s a setup that’s left investors sitting on fat returns from 2020, a year that defied easy explanation. It’s also one that has a growing cohort of experts warning about a bubble.

How can we know if we are in a growing economic bubble?

History offers clues, and a raft of current market conditions meet criteria that would likely be found on a bubble checklist.

Take a study by Harvard University researchers published in 2019. It noted that while not every stock surge meets with disaster, those that do share some attributes, including increased share issuance, heightened volatility, and a sector or index that doubles and is twice as high as the broader market. Check, check and almost-check.

Share issuance, initial public offerings and blank-check companies have grown so popular that record after record fell in 2020. U.S. companies sold $368 billion in new stock last year, 54% more than the prior high, according to data compiled by Bloomberg.

IPOs raised $180 billion, the most ever, as companies including Snowflake Inc., Airbnb Inc., and DoorDash Inc. took advantage of the rebound in equity markets. First-day pops in share price among the new comers were the biggest in two decades, according to Bill Smith, CEO and co-founder of Renaissance Capital LLC.

“Those are telltale signs,” said Robin Greenwood, professor at Harvard Business School and co-author of the 2019 study. He continued;

“The probability of a market correction is much greater today than in the historical average.”

And then there are SPACs; a subclass of IPOs took off in 2020 as well, adding to worries. Special-purpose acquisition vehicles, which use proceeds from a stock sale to acquire a private company, raised about $80 billion in 2020, more than was notched in aggregate over the previous decade. SPACs that made a purchase are up about 100% for the year. “That’s pretty bubbly stuff,” Greenwood wrote in a recent note, though he added that what’s “more remarkable” is that SPACs that have yet to announce deals have gained about 20%. “Obviously, this is pretty speculative behavior.”

Bubble warnings are liable to get louder in 2021, when companies will have to deliver profits that justify valuations that by historical measures have grown stretched. The S&P 500 ended the year trading at almost 30 times profits, meaning it will start a new year higher than at any time since 2000. The Nasdaq 100 is at 40 times earnings, a level not seen in two decades.

Other price trends have raised eyebrows. Bitcoin’s record-breaking advance. Heightened trading by retail investors that’s inflated previously little-known companies. Tesla Inc.’s 750% bulge. Through it all, the Cboe Volatility Index never closed below 20 after spiking to 80 in March. At 23, it remains above its long-term average of 19.5.

“As speculative juices flow, people become more entrenched with opportunities to make a quick buck. That could be dangerous,” said Marshall Front, the chief investment officer at Front Barnett Associates. “You never know how long the party goes, but it doesn’t end well."

Thinking ahead: Gold as a market hedge

Gold is traditionally a safe-haven asset. Throughout history, gold has often risen in value during a bear market.

Some examples:

- At the start of 2007, just before the financial crisis of 2008 began, gold was priced at US$800 per ounce. By the end of 2009, gold had hit US$1,300 per ounce. Gold rose in value by 60% while global markets were still in meltdown mode.

- In June 2016, gold prices surged $100 an ounce in six hours. Investors panicked in the wake of Brexit, when Great Britain voted to leave the European Union. Prices rose from $1,254.96 at 4 p.m. on June 23, the evening of the Brexit vote, to $1,347.12 at midnight. Investors bought gold as a hedge against a declining euro and British pound. In 2016, the U.S. stock market also entered a stock market correction. As the Dow Jones Averages fell, gold prices rose.

In conclusion, trying to call the top or bottom of the stock market defeats most professional investors, and it beats them all in the long run. Adding a little gold to your stocks and shares is a simple way to hedge your risk.