That’s the common refrain from people who are skeptical of the claim we’re in a bubble. Before I get into my response, I want to first put out the disclaimer that I’m not 100% certain we’re in a bubble. I’m like 85% sure we’re in a bubble. But you have no way of knowing for certain until it actually pops.
There’s basically two theories I have on bubbles, and both of them involve a balloon analogy:
- A balloon can be inflated until it reaches its maximum capacity and then bursts. In this analogy the stock market would basically implode in on itself. To go into another analogy, it would be like a plane that goes up too far and too fast, stalls out, the controls stop working, and then begins hurtling towards the ground.
- A balloon can be popped by an external force, i.e. a needle. This would be like a recession or some other external shock, say a global pandemic. In order for a bubble to be popped from the outside, though, it has to be sufficiently inflated and pressurized. Balloons that don’t have a lot of air or helium in them don’t really “pop” when they’re pricked from the outside, they just kinda deflate.
In analogy 1, what happens with markets is that they simply go up too high and too fast, meaning valuations reach ludicrous levels, and it gets to a point where there’s just no more demand for stocks at those ridiculous valuations. Once demand dries up, the market begins to drop, quickly, and then it begins a chain reaction where people get scared due to the rapidly falling prices, so they begin selling frantically, and then downward momentum takes over in the other direction.
On the upside of a bubble, prices are going up because prices are going up. People are buying stocks because stocks are going up, and then stocks keep going up because there’s strong demand for stocks. It’s self-fulfilling.
But on the downside, it’s the same basic principle at work, only in reverse: stocks are going down because stocks are going down. People don’t want to buy stocks that are plummeting in value. So stocks keep going down due to continued lack of demand. As stock prices plunge quickly, algos and stop-losses are triggered and they sell even more, accelerating the downward momentum. When markets are falling rapidly, it scares people away from stocks, and for those still in the markets, it compels them to sell, even at a loss, because they fear being completely wiped out. People reason that they’d rather sell at a loss than hold until zero.
And then when stock prices do find somewhat of a bottom and start rallying again, people take the opportunity to sell during the temporary reversal. If you buy a stock at 40, and then it falls to 27, but then bounces up to 32, a lot of people are going to sell at 32, because their portfolio isn’t down as much as it was at 27, so they feel like they’re at least a little bit closer to breaking even, and they can accept selling at a smaller loss than they had when the stock was at 27. Fear has taken over: people are happy to sell at a loss because they fear even greater losses. It’s the complete opposite of greed, where people hold even when they’ve made good profits, because they want great profits. This fear-based selling is how you get bear market rallies, which always peter out below the prior highs: because people take the temporary reversal as an opportunity to sell.
Basically in analogy 1, the same momentum that takes stocks up rapidly also takes them down rapidly. Momentum works the other way now.
So I guess that’s my answer for how we can be in a bubble despite everyone actually knowing we’re in a bubble. Even if people know stocks are in a bubble, everything’s fine as long as stocks are still going up. People will still buy at high prices as long as they feel confident they’ll be able to sell at even higher prices.
But the higher the market goes, the more cognizant people become of the bubble, and it makes them quicker to sell. Markets get spooked more easily in the late stages of a bubble because people look at every bit of bad news as “Is this it? Is this the end?” Investors have a hair trigger with the sell button during the later stages of bubbles, because they’re aware, on some level, that this could all come crashing down at any moment. They know they’re on borrowed time and the ice is getting thin, so they’re on high-alert for any reason at all to pull out of the market.
To illustrate this point, consider that the Nasdaq had 7 corrections of 10% or more from February 1, 1999 to February 1, 2000. And yet the index was still up over 75% during that span. In the late stage of a bubble, investors are on high-alert:
If there is no bad news that tanks the market, then eventually valuations will get so obscene that there just won’t be any demand anymore. As the old saying goes, “The cure for low prices is low prices.” Well, the opposite is also true: “the cure for high prices is high prices.” This is why bubbles can’t just keep going higher indefinitely. Eventually valuations get too high and nobody wants to buy anymore.
So I guess my answer is, “Bubbles burst when enough people become aware of the fact that stocks are in a bubble and completely detached from reality.” What that magic number is, I have no idea. I don’t know if there’s any hard and fast rule like “when X% of investors become aware that the market is in a bubble, that’s the tipping point.” As far as overall market P/E ratios go, it’s also tough to say because with each major bubble (1929, 2000) in US history, the market has set new highs in terms of overall valuation.
As far as momentum goes, however, the upshot is this: the same momentum that took the market up to ridiculously overvalued levels will also take the market down to ridiculously undervalued levels. Stocks will sell off too much after a bubble pops. The extreme enthusiasm and greed that led the bubble to its peak gives way to extreme despair and fear, which will result in stocks becoming oversold. In the upward part of a bull run, the market can shrug off bad news. But when stocks are crashing, every bit of bad news compounds and sends the market even lower. It’s when you have people swearing off stocks for good, “I’ll never buy stocks again,” etc. There’s a sense that stocks might never go up again. This is when you buy back in.
With regard to analogy 2, where the bubble is burst by an external shock, the main factor here is just how drastic of a shock it is. For example, in 1998, when Long Term Capital Management collapsed, it caused a serious correction in the market (19%), but it wasn’t enough to derail the overall bull market. The market bottomed out in early October, and by December it was at new all-time highs.
Even with Covid, as much as people want to call the March 2020 Covid Crash a bear market because it crossed the threshold of -20% or more, it did not actually derail the long-term uptrend of the market. Even though the S&P 500 fell 35%, when you look at the market on a long-term chart, March 2020 was really not that bad in the grand scheme of things:
It still resumed the up-trend afterward.
The Covid Crash bottomed on March 23, 2020, and by August 20, 2020 the S&P was already at new all-time highs. Even if you bought an S&P index fund on February 19, 2020, the day before the markets started tumbling, as long as you held, you’d be up over 16% today. The S&P, altogether, only went 180 days between all-time highs. From the bottom, it only took 149 days for the S&P to fully erase the 35% decline.
With Covid, the general feeling was, “Yeah, this is going to be bad, but it’s going to be temporary; we’ll get through this.” Plus the Fed and the federal government took extraordinary measures to pump the markets back up. More than anything, the Fed’s actions reassured investors and restored their confidence in the market because the message was, “The Fed is not going to let this thing collapse.” It was safe to get back into stocks.
Nearly a year later, it’s clear that Covid was not enough to take down the bull run. It was not a big enough external shock. Ultimately it only caused a short-term correction in the markets, even though it was a very severe correction.
An external shock may not always pop the stock market bubble. If there was an appetite for stocks before the external shock hit, then most of the time, as soon as the bad news blows over, the market will resume going up because the fundamental, long-term outlook on the market has not changed.
So what’s a big enough shock to actually end a bull market?
In 2008, when the world entered the Great Recession and big Wall Street banks started going belly up, that was enough of a shock to kill the bull market. A recession is the most common external shock that kills bull markets, and it’s pretty self-explanatory as to why: most companies are about to cease making profits, or at least see their profits take a serious hit. At the time in 2008, it felt like the whole world economy was about to go off a cliff.
The fundamental outlook on markets had changed. No longer were investors optimistic about the market’s future, they were deeply pessimistic. Apocalyptic, even. The global financial crisis was no mere short term problem. It changed everything. Even though the market was not terribly overvalued in 2007, the GFC cut the bull market short.
So what’s going to end this stock bubble? When prices get too high, or when a big enough external shock comes along and sends markets into a tail spin?
Here’s the thing: most of the time, when stocks enter a bear market, it’s not strictly analogy 1 or strictly analogy 2. It’s not an either-or thing.
It’s usually a combination of the two: stocks reach obscene valuations, and then the clouds of recession begin to appear on the horizon, which causes demand for stocks at current valuations to dry up.
If the economic outlook is still good, then even at sky-high valuations, stocks will only go into a short-term correction and then bounce back and make new highs. High valuations can not only persist for a long time, but they can go way higher than anybody previously thought possible:
Stock valuations are high today, but they were also high in early 2018. And while the market traded sideways for a while then and valuations came down somewhat , it didn’t collapse.
Prior to 1929, the high point for stock valuations was about 23 right around 1902. During the bull run of the 1920s, the market hit the 23 level in about 1927 and still kept going up for another two years until peaking at a Shiller P/E level of 30. The lesson: markets can always get more overvalued–they can always surpass the 2000 peak.
Look at the 1990s: stocks were pretty richly valued even by 1994. But they still kept going up. By about 1997, they had reach the valuation extreme of the 1929 peak with a Shiller P/E of 30, but it didn’t matter: they kept on going up and up until finally peaking out at 44 in 2000.
Markets right now are as richly valued as they’ve ever been other than 1999/2000. But who’s to say valuations today can’t go as high as they were in 1999/2000 or perhaps even higher?
It’s entirely possible they do.
***
The most remarkable thing about the stock market is how fast it is at getting to the bottom line, or jumping to conclusions. I mean this in a good way. Markets take one data point, analyze it, and figure out the ultimate implication with unbelievable speed. Want to know why Tesla is trading at such an obscene valuation? Because the market doesn’t care what Tesla’s profits are now. The market values Tesla as the company that is literally reinventing the automobile. Everything that you believe Tesla is capable of achieving in the future–maybe even 10, 15, 20 years down the road–the market has already priced into the stock today. It’s amazing, honestly.
The market has already priced in all the future implications of what a company is doing currently. They’ve taken the “if, then” game to its conclusion with basically every stock out there. Companies share prices don’t reflect what the company currently is, they reflect what the company can one day become if it realizes its full potential. The market has already gamed everything out to its logical conclusion.
It’s happening right now, by the way. The Nasdaq recently fell because the 10 year yield started rising. Well, so what? Well, the 10 year is rising because the bond market thinks inflation is going to accelerate. Well, so what? Well, if inflation accelerates then the Fed is probably going to have to raise interest rates in response, which is bad for the stock market and could even cause a recession. See how the market has already analyzed and priced-in the full chain reaction of the rise in the 10 year yield? We haven’t even seen inflation pick up, much less a rise in interest rates, and the market was already selling off in anticipation.
It’s really quite amazing when you think about it. The market is unbelievably quick at understanding the full, long-term ramifications and implications of a given event.
It’s why I say the Dot Com bubble wasn’t wrong, per se. It was just early. The market fully understood, by the mid 1990s, that the internet would change everything. They were just too early on the timing.
If you go look at the long-term stock charts of the biggest tech companies of the 1990s–Microsoft, Cisco, Intel and Oracle–you can see that they only surpassed their 2000 share prices in recent years (although Intel is still below). Here’s Microsoft for example:
The market wasn’t wrong about Microsoft in 2000. It was just 15 years early.
Cathie Wood always says the seeds of the present tech industry were planted in the late 1990s, and this is what she’s talking about. Back in the 1990s, most of these tech companies weren’t profitable. But now, the “MAGA” stocks (Microsoft, Apple, Google, Amazon), or the “FAANG” stocks (MAGA + Facebook and Netflix), are the most profitable companies in the world. They basically print cash now.
But while the darlings of the Dot Com bubble are now all grown up and have turned into the companies investors in the 1990s thought they one day would, that does not mean that we’re not in another tech bubble today.
Microsoft, Intel, Cisco and Oracle were not “the tech bubble.” Sure, they were overvalued by 1999/2000 (like everything else), but they were still, at the end of the day, real companies providing real value and generating real profits. It was the other, smaller companies–like WebVan, Pets.com, Netscape, and the dot com startups that went public and soared despite not generating any profits, and in some cases even any revenues–that were the real bubble.
Similarly today, while the FAANGs are very richly valued, they are not the poster children of the stock market bubble. It’s the Pelotons and the Zooms and, yes, the Teslas, stocks which are trading at insane valuations, that are the examples of the bubble. It’s Roblox trading at a $45 billion valuation despite being unprofitable. It’s the GameStops. It’s DoorDash having a $50 billion valuation despite the fact that there are tons of other companies that do exactly what they do. It’s UBER and AirBnB having $110bn and $120bn market caps respectively despite neither company being profitable.
According to Business Insider, “There are now more zero-revenue public listings valued at over $1 billion planned for 2021 than there were in any year during the dot-com era.” This is largely a result of the SPAC craze. Last June, NIKOLA, the electric car maker that went public via SPAC, got all the way up to a $29 billion valuation despite zero revenues. It’s down considerably now, but Lucid Motors is also a zero-revenue company and about to go public via SPAC. A lot of these EV startups are “pre-revenue” and still getting crazy valuations.
The market is probably right about the transformative potential of Tesla and the EV startups–one day. But at a certain point, when the economic outlook for the future worsens and risk appetite turns to risk aversion, investors are going to dump these stocks en masse in favor of companies that are actually making profits. Suddenly, these high P/E, high-potential companies will become unattractive as they’ve been bid up to valuations that will take them years and years to ever live up to.
When investor enthusiasm and optimism falls, so will all of these high-flying stocks.
Okay, so what’s going to be the external shock that pops this stock bubble?
We don’t know yet. If we knew, then stocks would already be crashing. We’ll only know after it happens.
What if it’s the stock market itself? Can a stock bubble imploding in on itself tank the economy? It’s possible that a stock crash can contribute to an economic decline, sure.
When stock prices start falling, it causes people to have less confidence in the overall economy. Because so much of the wealth of the economic elite of this country is tied to the stock market, when the market drops, so do their net worths. They begin to spend and invest less and start playing defense, so to speak. They go into capital preservation mode. Venture capital money starts drying up. Companies with weaker balance sheets start to fail, which then has real economic ramifications.
But I don’t believe a falling stock market straight-up singlehandedly causes an economy to go into recession, because usually it’s the fear of a slowing economy that causes the stock market to fall in the first place. A falling stock market can and often does hasten the onset of a recession by undermining confidence in the economy, but the stock market generally hasn’t had the ability to kill an economic expansion all on its own.
As we went over above, the market is forward-looking in nature. Stocks generally roll over before the recession actually begins. The Nasdaq peaked in March 2000, and the S&P 500 in September 2000, but the economy didn’t actually enter recession until March 2001. Before the GFC, the stock market peaked in October 2007, while the official start of the recession was two months later. And it really wasn’t until fall 2008 that everything really went in to freefall. The S&P was only down about 17% from its 2007 high even as far into the bear market as early September 2008.
The market falls because it sees trouble ahead.
***
It’s not like in past bubbles nobody knew stocks were in a bubble. Roger Babson was a famous investor in the 1920s, and he was publicly warning about an imminent collapse since at least 1927. His comments on an impending market collapse in September 1929 not only rattled markets, they may have actually been the first domino to fall in the stock decline that led to Black Tuesday. Former Fed Chairman Alan Greenspan made his “irrational exuberance” comments in late 1996. If the Fed Chairman publicly remarked on bubbly behavior in the markets as early as December 1996, then clearly it was no great secret in the ensuing years that markets might be in a bubble. Robert Shiller released his book “Irrational Exuberance” in March of 2000, right at the peak of the bubble.
It just defies belief to suggest people in the late 1990s and in the 1920s were largely unaware of the fact that stocks were in a bubble. People aren’t stupid. In my view, the people who say “we can’t be in a bubble if people know we’re in a bubble” are trying to convince themselves everything’s fine and their portfolios are not at risk.
There can absolutely be a bubble even if a large portion of investors are aware of it.
I think the real question is “How com this bubble hasn’t burst even though a lot of people know we’re in a bubble?” In my view there are a few possible answers. I will rank them from least to most likely.
- We’re not actually in a bubble. It’s certainly possible we’re not, but valuations would suggest we are in a highly exuberant environment, i.e. a bubble.
- Not as many people are aware of the bubble as you think. A large number of people understand that the market right now is not sustainable and not going to end well. But there are a lot of true believers out there. Just go on r/WallstreetBets and you’ll see them. Those guys talk like the market will go up like this for years to come. They’re YOLOing into call options for 1 and even 2 years out. They think it’s going to keep going up. Plus, for every prominent investor saying we’re in a bubble and it’s about to burst, there’s dozens of articles in prominent publications “debunking” their bubble warnings. I think a lot of people know it’s a bubble but are still invested because there really hasn’t been any truly scary sell-off since Covid–there hasn’t been any serious indication that the party is ending. For example, I think we’re in a bubble yet I still have a decent chunk of my portfolio in a long position. I’m holding it because I, like everyone else, believe I can get out before the whole thing collapses. I probably won’t; I’ll probably get burned, along with everyone else, because markets don’t ask investors if they’re ready for a crash before they crash, but that’s still my mentality right now. Once I sense imminent danger, I’ll go to cash.
- It’s already in the process of bursting. This is quite possible. The Nasdaq is still 6% below all-time highs and has already put in a head and shoulders top. The Nasdaq might already be in early stages of the next bear market. We have to wait and see.
- It still has room to run. This one, I think, strikes me as the most believable scenario. I could be wrong, but I think in order for this thing to go full bubble and then burst, it needs to really get out of control. It needs to go vertical for like 3-4 months and turn in to a full-blown bonanza. The final stage of a bubble is the blow-off top, and I don’t think we’ve seen that yet. From October 18, 1999 to the peak of the Nasdaq bubble on March 10, 2000, the Nasdaq went up a whopping 95%. That’s near a doubling in 147 days. It went up 38% just in the month of February 2000. From October 12, 1998 to March 10, 2000 the Nasdaq rose an astonishing 277%. We’ve seen something similar since the Covid bottom, as the Nasdaq rose 116% between March 23, 2020 and February 16, 2021. So we’re almost there, but I think there could be one final explosion higher before this thing is over with; the blow-off top. I would not be surprised if we see the Nasdaq hit like 17,000, the S&P hit 4,500 or even higher, and the Dow hit like 35,000 within the next 3 months. When that happens, you know the end is near.
If we are still in fact awaiting the final blow-off top, then it’s probably going to coincide with a significant surge in inflation. As we went over the other day, Americans are sitting on a record level of savings, and that money (plus the just-signed $1.9 trillion stimulus) is expected to be the catalyst for the inflation after the country reopens in full. Some of that money will undoubtedly be plowed into stocks, and bullishness over reopening will probably lead to a surge in retail buying (in additional to the surge in retail investing that has happened over the past few months). I think it’ll take stocks to new highs.
The Fed has indicated that they’ll let that whole process play out and not hike interest rates, with the assumption being that the surge in inflation will be temporary.
But it’s a risky game. What if the inflation persists?
The Fed will then be forced to hike rates if they get behind the eight-ball on inflation. They might have to hike rates rapidly in order to get things under control.
Rate hikes will not be good for the still-fragile economy. But the Fed will have to choose between keeping inflation in check or fighting unemployment, and I think they’ll choose to fight inflation. The economy will suffer because rates will have to remain high in order to combat inflation.
This is the chain of causation to remember: bull markets end when the market senses a recession on the horizon. Recessions are caused by high interest rates. The Fed raises interest rates in response to rising inflation.
Therefore, inflation kills bull markets and pop stock bubbles.
If inflation gets out of hand, the Fed will have to hike rates fairly dramatically. It takes pretty high damn interest rates to get inflation under control, and high rates cause very painful recessions. Just look at the early 1980s for proof of that.
Stock valuations back then were not anywhere near as elevated as they are today, too. This spells very bad news for the stock market, but remember it’s all predicated on the assumption that the coming surge of inflation is temporary and does not get out of control.
That’s what this all hinges on.