The bubble hype
Financial markets have a funny way of attaching labels to data points as if they have some predictive value. Case in point, a “bear market” is a 20% fall from a market high while a “bull market” is a 20% gain from the lows. This is often followed by the average length of a bull/bear market, with so few examples, these comparisons tell us very little about the future.
Similarly, the present obsession with whether the current market should be labelled a “bubble”. As the following chart shows, Google searches for the term “stock market bubble” have taken off in recent months as the market has surged to record highs on the back of the AI trade.
The problem with simplistic labels is they tell us next to nothing about the future. Stock market bubbles are particularly hard to identify and are typically only recognised after they have burst, largely because they combine elevated prices and a compelling narrative.
Financial historian James Grant says, “there are three common features of a bubble: one part fundamental (i.e., a technological revolution), one part financial (i.e., a surge in money and credit) and one part psychological (i.e., a suspension of belief in traditional valuation measures).”
These three common features of a bubble can be likened to the fire triangle which consists of heat, fuel and oxygen. As just like a fire all three must be present for a bubble to ignite, and removing any one of them extinguishes it.
Inside the bubble triangle
Heat: The fundamental underpinnings of the current market exuberance are apparent for all to see, with the AI boom likely to transform the economy. The downside of technological revolutions is they often lead to money flowing to projects that will never earn an adequate return, as the advent of railways and the internet did in their time, where overinvestment destroyed capital even while sowing the seeds for future economic growth.
Fuel: If AI has created the heat that has propelled markets to record highs, then money and credit have created the financial fuel. The $30 trillion US government debt is currently increasing at more than $6 billion per day, while households and businesses each owe more than $20 trillion.
Oxygen: The third and arguably most important feature of a bubble is the psychological excess, the mania or FOMO that adds oxygen to the fire. While it is hard to claim that irrational exuberance has infected the wider market there are signs of excess in the AI ecosystem where hundreds of billions of dollars are being invested in the race for AI supremacy.
As outlined above, all the ingredients are there to suggest there may well be a bubble in financial markets, however, there are few signs of the mania usually associated with the late stages of a bubble.
Where are we in the cycle?
The key questions are: where are we in the bubble cycle, and what do we do with this information? Do you rush to buy the bubble à la legendary hedge fund manager George Soros, secure in the knowledge you can leave the party before the music stops playing, or do you sit on the sidelines when this time may indeed be different.
What this means for investors
If we can’t determine where we are in the cycle, what can today’s valuations tell us about future expected returns. An often-repeated maxim of markets is the higher the price you pay, the lower the expected return. While most valuation measures currently point towards US markets being expensive, some such as the Buffett Indicator (a gauge of the size of the share market relative to the economy) are currently at record highs.
Quantitative investors, or quants, like to define bubbles more systematically, typically as a two standard deviation event. In a normal distribution this would equate to the top 2.3% most expensive markets, however that is defined. Rare but not overly so.
To put it in numbers, at a current valuation of 22.9 times next year’s earnings the S&P 500 is well above its 30-year average of 17.1 times. Remember earnings expectations in this instance are based on analyst forecasts which are notoriously overoptimistic. If history is anything to go by, the prospect of the market delivering a positive return from these extremes over the next 10-years are slim.
Interestingly retail investors (along with equity analysts) tend to extrapolate recent growth as a proxy for future returns while institutional investors tend to believe in mean reversion. We believe both are suboptimal strategies.
While investors who project past returns into the future are likely to benefit in the short-term, they also open themselves up to sharp reversals and drawdowns that may offset any gains. Meanwhile investors who believe markets will revert to more normal valuations are likely to underperform in the short-term while also missing periods of regime change when conditions change in a lasting way.
Thankfully for us the choice isn’t all or nothing. While it would have been nice to have owned some of the high-flying tech stocks over the last few years, we sleep easier at night since we don’t. Today, non-U.S. equities, deep value stocks, and liquid alternatives all offer returns that look reasonable or better, regardless of whether AI is in a bubble.
Get in touch for a confidential obligation-free discussion on how alternatives can support your long-term financial goals.