One of the greatest positives to come out of 2020 is the impressive development of covid vaccines. From virtually a standing start, drug companies and national health departments have worked around the clock to successfully create inoculations against a pandemic scourge that has brought the world to a crawl.
And not a moment too soon. Western governments had naively forecast that covid would peak in the spring, and summer weather would do the rest, leaving the virus under control by year’s end. Nothing could have been further from this winter’s reality, as cases in the U.S. have mushroomed in the wake of Labor Day and Thanksgiving, while new covid mutations have been discovered in Europe (and now, the U.S.).
That there would eventually be a vaccine is a testament to the human commitment to progress and to the trust placed in the scientific method. The advances we enjoy today are the cumulative result of innumerable rounds of trial and error that have winnowed the successes from the failures. Moreover, the free exchange of ideas has allowed us to build on past successes; we do not have to go back to the drawing board to solve each problem that comes our way. Mercifully, this has allowed covid vaccines to be created in record time.
In contrast to the worlds of medicine and engineering, where progress is cumulative, progress in the world of finance is cyclical. While financial promoters would like their customers to believe that new eras are always upon us, the plain truth is that the factors that govern the world of money ebb and flow. Interest rates, company profitability, inflation and human fear and greed all oscillate over time. While history is rife with examples of governments trying to manipulate financial markets for their own ends (as central banks are doing today), they have never been able to permanently hold back the tides of financial cycles.
This ebb and flow is what makes “regression to the mean” such a powerful force where finance is concerned. That makes the extremes we are seeing now in market measures all the more worrisome. All indications lead to the conclusion that we are in yet another stock market bubble, the third one of the 21st century.
Stock market valuations are not only high, but they have also exceeded the bubble peaks of 1999-2000. Now, as then, investors are throwing any pretense of “value” out the window as momentum chasing has been substituted for security analysis. This has led to an enormous expansion of stock prices, but without a commensurate rise in revenues or earnings. Comparing stock market capitalization to the economy puts today’s bubble into perspective. The “Q Ratio” was developed by Nobel laureate James Tobin and measures the total price of the market divided by the replacement cost of all its companies. Going back to 1900, markets peaks have occurred when stock market value has equaled about 1.0x the value of its underlying companies (1929, 1968, etc.) The internet bubble drove the market to 2.15x the value of its underlying assets in 2000. We have now exceeded this peak by a wide margin and are now trading at about 2.5x the underlying assets. Nor is this measure alone in signaling peak valuation. The S&P 500, on a trailing basis, now has a 27.4x price-to-earnings multiple. Only 0.4% of the time in the past 70 years has the multiple been so rich. The smoothed cyclically adjusted PE ratio (CAPE) multiple says the same thing: no matter how you slice it, stocks are priced for perfection.
Debt creation is another hallmark of the current financial markets. As central banks globally drove interest rates down to near zero (again) it unleashed a borrowing frenzy. Corporations, which had already leveraged up and used the proceeds to buy back stock, have increased their debt at a record pace, leaving them with higher debt-to-equity ratios than at any time since 1929. Debt has of course increased at the government level also, as Treasury debt has ballooned to pay for economic relief packages and municipalities have borrowed to pay employees as tax revenues have plunged due to the effects of the pandemic. The federal budget deficit has tripled in one year: It ended 2019 at about $1 trillion, but is now at $3 trillion. Total federal debt now represents 127% of gross domestic product, and like the Q Ratio above, is at an all-time and showing no signs of abating.
Stock investors, too, have taken their cues from the Federal Reserve and increased their margin debt to all-time highs. The risk here is that any price correction can rapidly snowball as highly leveraged investors are forced to meet margin calls in even a small downturn. Frequent price declines are like pressure relief valves for the market, allowing skepticism to build along with cash. Unfortunately, we have had very few of these since March, with the result that cash levels are not only low, but negative in the sense that investors have borrowed on margin to enhance their returns. Today’s high levels of margin debt, combined with excessive corporate debt, are indicative of the bubble-like nature of the market, and a belief that stocks can only go one way: up.
Finally, investor behavior is a major clue to whether we are in a bubble, and today’s behavior certainly reinforces that conclusion. Initial public offerings (IPOs) have been red-hot this year as many marginal companies are offering stock to try to take advantage of the receptive mood of investors. Some IPOs have been spectacular, but also point out the levels of absurdity that we have reached. Door Dash, a restaurant food delivery company, went public in December and quickly doubled from its IPO price, giving it a valuation of $70 billion. This is for a company that is losing money which has low barriers to competitive entry. That valuation ranks it about equal to FedEx and Colgate-Palmolive, and above Walgreens, Northrop Grumman, and ConocoPhillips. For a food delivery company?
Similar examples of speculative behavior can be found in the popularity of SPACs and the cryptocurrency Bitcoin. SPACs are “special purpose acquisition companies,” which are companies that have no assets and exist only to acquire other companies. These used to be called “blind pools” because you never knew what you were going to be invested in—it was a matter of the promoter saying, “trust me, I’ll do something good with your money.” Bitcoin is an electronic creation its fans like to call a “currency” but is simply a speculative vehicle with no underlying assets. It exists simply because people believe it has a value and has captured the fancy of investors with its dramatic price rises.
Bullish sentiment, as measured by Investors Intelligence, has been over 60% for five weeks, an extreme reading that has been consistent with market peaks in the past. Bearish sentiment, at 16%, is among the lowest bearish readings in the history of this indicator (going back to the mid-1960s). Sentiment tells us that investors have gone “all in” on stocks, and that there is little fear of downside risk. History, of course, has taught us that that is exactly when investors should be worried. As Bob Farrell, former chief strategist at Merrill Lynch wrote in his 10 Rules for Investing, “When all the experts and forecasts agree—something else is going to happen.” Today’s lopsided bullish psychology is an alert to investors to watch for a change of the prevailing trend.
Financial bubbles are always spawned by an overriding concept that has a basis in reality. In the 1920s it was the new technologies of radio, airplanes, and automobiles. The 1960s “Go-Go” era was based on the invention of the semiconductor and rise of tech companies such as IBM. In the late 1990s the advent of the internet prompted investors to embrace new era thinking, while in the mid-2000s the mortgage bubble was founded on the belief that real estate prices would never go down, and so were much safer than stocks.
Today’s conceptual meme is that the Federal Reserve and its cohorts will perpetually support the markets through its money printing (i.e. quantitative easing, or QE) efforts, and that they have eliminated the downside risk of investing. But this assumes that the marginal benefits of QE will remain constant, and not be subject to diminishing returns. That is clearly not the case, as QE in Japan and Europe has gotten to the ridiculous extreme of pushing interest rates into negative territory, yet both those regions are experiencing the most anemic growth in fifty years.
We believe that even the omnipotent Fed is subject to the laws of diminishing returns at the very moment when valuations are at extremely high levels and investor psychology is maximum bullish. Central banks have made the conscious, and fateful, decision to short-circuit capitalism’s adjustment process. Investors have embraced this notion and seem to believe the natural ebb and flow of financial cycles have been repealed, and in their zeal have created yet another financial bubble. But the Fed’s efforts to eliminate risk only serves to make the markets more leveraged, and therefore more fragile. Evidence points to being in the late stages of the current bubble and investors should prepare for its likely deflation in the coming year.