Are sectors of the US share market in financial bubble territory?

Finance & Fury Podcast

Welcome to Finance and Fury. Are sectors of the share market in a bubble, one in particular that comes to mind would be the US tech sector.

There have been many bubbles in financial markets throughout history – if enough excitement is generated around some new asset, or commodity that is seen as the next big thing and everyone starts buying – bubbles can emerge in prices

1. covered some of them, south sea bubble, tulip mania – one that may be the most similar is the dotcom bubble –
2. But how exactly is a bubble designed? And what metrics can be used to measure this
3. The traditional definition of an economic bubble – “An economic bubble or asset bubble is a situation in which asset prices appear to be based on implausible or inconsistent views about the future. It could also be described as trade in an asset at a price or price range that strongly exceeds the asset's intrinsic value.”
4. However – the intrinsic value – or fair value of an asset can be fairly subjective – especially for new or emerging companies or assets
   1. As an example – think about CBA for a minute – the fair value should be one of the easiest to calculate as far as shares go – underlying earnings are well known – forecasts also pretty easy based on the business model and the availability of their financials and stability in their results meeting market expectations
   2. Many analysists cover it – the price tends to be around what the fair value is estimated to be – the fair value between brokers ranges from $78 to $90 – and so the price ranges between these – currently trading at $82
   3. There isn’t much growth estimated in CBA – what about tech companies – or emerging businesses that are forecasted to have massive growth?
5. This is when bubbles can emerge – nobody wants to miss out on the potential growth in the future – so everyone jumps in today – pushing up the price to what may be fair value in 10 to 20 years
   1. But some companies can get to the point where they are still losing money – have many competitors – don’t have market share – but yet they are trading as the next big thing – which they well may be – but it is speculation –
6. One company in a whole market doing this isn’t a bubble – this happens all the time – you get some companies go up 1,000% - before crashing back down to earth
   1. But when a whole sector of the market – or the whole market in general is trading at a massive forward PE – this could be starting to look like a bubble territory
   2. I was reading an article that ray dalio published – about how he has a “bubble indicator” that helps to give perspective on each market

What is the bubble indicator - What I mean by a bubble is an unsustainably high price, and how I measure it is with the following six measures.

1. How high are prices relative to traditional measures? - The current read on this price gauge for US equities is around the 82nd percentile, shy of what we saw in the 1929 and 2000 bubbles. Traditional measures are estimates like PE, yields and future earnings.

1. 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 looks at the fundamentals of a company based around the discounting rates – i.e. a 10y gov bond. Currently this indicator is around the 77th percentile for the aggregate market. This indicator shows that while stock prices in aggregate are high in relation to the absolute returns they are to provide, they are not extremely high in relation to their bond market competitors. In both 1929 and 2000 this measure was at the 100 percentile- interesting about this is that the real returns on bonds change with inflation expectations as well

1. How many new buyers (i.e., 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. That is because they are typically entering the market because it is hot and don’t want to miss out. Many new buyers don’t have any experience with markets (hence new buyers) – so the warning signs of a company being overpriced can be missed. This was the case in both the 1929 and 2000 equity bubbles. This gauge has reached the 95th percentile recently due to the flood of new retail investors into the most popular stocks, which by other measures also appear to be in a bubble.

1. How broadly bullish is sentiment? - The more bullish the sentiment, the more people have already invested, so the less likely they will invest more and the more likely that they will sell. The aggregate market sentiment gauge is sitting at around the 85th percentile. Once again, it is heavily concentrated in the “bubble stocks” rather than most stocks.

Also - IPOs have been exceptionally hot—the hottest since the 2000 bubble.

The current IPO pace has been brought about by the sentiment previously mentioned, as well as the SPAC boom - special purpose acquisition company (SPAC) is a corporation formed for the sole purpose of raising investment capital through an initial public offering (IPO). these acquisition companies have lower regulatory hurdles and greater flexibility to bring more speculative companies into the public markets.

1. 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 in the US market, 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 just shy of the 80th percentile. So there is high level of leverage being deployed by the retail segment (using options) in “bubble stocks,” while there is much less leveraging by other investors and in non-bubble stocks. Volume in single-stock call options is at record highs. Retail purchases of options have been the big contributor to this surge. Outside the retail sector we aren’t seeing excessive leveraged buying.

1. Have buyers made exceptionally extended forward purchases (e.g., built inventory, contracted forward purchases, etc.) to speculate or protect themselves against future price gains? - One perspective on whether expectations have become overly optimistic comes from looking at forward purchases. We 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 we look at indicators like capital expenditure—whether businesses (and, to a lesser extent, the government) are investing a lot or a little in infrastructure, factories, etc. It reflects whether businesses are extrapolating current demand into strong demand growth going forward. This gauge is the weakest across all our bubble gauges, pulling down the aggregate read. Today aggregate corporate capex has fallen in line with the virus-driven hit to demand, while certain digital economy players have managed to maintain their levels of investment.

What to take away from this -

1. Each of these six indicators influences is measured using a number of stats that are combined into gauges – these indicators are simply estimates as well - they are combined into aggregate indices by security and then for the market as a whole. Ray has put similar data into the market since 1910 – how does the market stack up?
   1. 1920s
   2. Dotcom
   3. 2007
   4. US market today
   5. US market - tech
2. Comparing the share of US companies that these measures indicate being in a bubble - It is about 5% of the top 1,000 companies in the US, which is about half of what was seen at the peak of the tech bubble. The number is smaller for the S&P 500 as several of the most bubbly companies are not part of that index.
3. However – these bubble shares – or the 50 companies in the US – have had good performance – especially when compared to the rest of the top 500 companies.
   1. 50 in bubble – 350% returns over past year
   2. Rest 25% returns

Conclusion –

1. What to take away from all of this – firstly, these gauges are not perfectly accurate - Even if you were timing tops and bottoms based on what neighbourhood share are in - there is nothing precise about this.
   1. it is tough to pick the levels and timing of tops and bottoms based on it.
2. May seem like some things point towards bubble – but doesn’t mean it can’t continue up – that is the problem with anything in a bubble – the ride can continue – Or prices can falter out
3. Whilst many tech companies do seem overvalued and in a bubble territory due to traditional pricing metrics – there can be some fundamental reasons why
   1. Quest for yields and real returns –
   2. Store of value if cash is being devalued - so with new entrants and many market participants having familiarity with certain companies – such as big tech businesses – they invest into them
   3. If you are worried about a crash in prices – then either invest a small amount into an index or avoid companies that appear overvalued – well beyond normal growth share metrics – like PEs in the 50s -
4. Next week – look at the risks of rising yields – many tech companies are non-profitable – what happens when yields on their corporate debt starts to rise?

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https://www.bridgewater.com/research-and-insights/ray-dalio-stock-market-bubble