Is The Stock Market In A Bubble?
There are many signs that the current stock market is in a bubble, but calling the top is extremely difficult because of the heavy involvement of the Fed in this market cycle. In general, here are several indicators that the top is very near:
1) Extraordinarily high valuations
2) Heavy retail trading in a “new” paradigm
3) IPOs of companies with remarkably weak finances
4) Hedge funds failing with eye popping losses
5) A persistent recession or economic slowdown
Long term valuation metrics are high everywhere: price-to-earnings, price-to-sales, and price-to-GDP. P/GDP is probably the easiest one to comprehend because it compares the size of the public companies with US GDP. The following chart does not include the 2000 market peak, but you get the idea.
Robinhood is a trading app that revolutionized small investor trading in 2018 by offering trades with no commissions. Discount brokers like Schwab and E*trade followed suit in 2019, reducing trading costs to nearly zero. But for the established players, it was too late. All the young, speculative money went into Robinhood to day-trade stocks and bitcoin. Last week, an enormous short-squeeze on Gamestop (ticker GME) was precipitated by Robinhood trading of stock and options. On Wednesday last week, Robinhood began running into funding problems and was forced to reduce trading along with Interactive Brokers.
Typically, hedge funds run portfolios that are long stocks like Apple and Facebook while selling-short stocks like Gamestop and AMC Networks. This is called a pairs-trade and is fairly common. A problem arises if there is a sudden need to reduce risk across the board, investment funds will both Buy the short names (GME and AMCX) and Sell the long names (AAPL and FB) in this example. It is unclear if this risk-off rotation is temporary or a more serious negative change in the Market Narrative. It is too early to say, yet.
In 2020, initial public offerings (IPOs) were very active. Historically, companies came public after years of growth or building their business. Not today. No, today most of these companies had minimal sales. In some cases, they had no revenues at all and were sold as concept or high-growth potential companies. Even during the tech bubble of 2000, this was rarely done. The combination of heavy retail trading and extreme speculative IPO activity are classic signs that a bull market is fully mature and may be coming to an end.
Another sign of a market top is the failure of a flagship hedge fund. Last week, Melvin Capital announced January losses of 53%, mostly from shorting Gamestop and a few other stocks. They ended 2020 with $13 billion in capital; today it is $8 billion and falling. The failure of a major fund creates systemic risk for the financial system because many entities are in the lending chains surrounding these trading shops. A default or loss may ripple from one entity to another or trigger risk-off policies like that of Robinhood and Interactive Brokers to lower risk to the brokerage firms themselves.
The economy isn’t doing great. Last year, economists forecast that 2021 was going to be a great year with stimulus pushing GDP growth above levels last seen in 2019. So far, those hopes have not been realized and with unemployment rising, economic growth may decelerate.
Finally, I will leave you with links to one of my favorite market strategists and historians, Jeremy Grantham. He is a legendary investor in the same league as Peter Lynch and George Soros, but still speaks publicly about the markets. He is very bearish on stocks and compares the current market environment to 1929 and 2000. Now, in fairness, he called the 2000 and 2008 market peaks early and lost $1 billion shorting equities in 2020. There are rumors his funds were short beginning in April 2020, so they suffered terribly in the stimulus induced rally from the pandemic bottom. Eventually, he was vindicated in his past views; we are living through what is probably his last major prediction.
Grantham letter: Waiting for the Last Dance (gmo.com)
With these facts in mind, you will understand why we are positioned conservatively in all our portfolios. How are you positioned?
We would love to discuss the implications of this research on your personal situation.
Robert Lloyds, CFA®
Chief Investment Officer
Lloyds Intrepid Wealth Management
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