Let me throw something at you to ponder for a moment.
“Stock market bubbles have NOTHING to do with valuations or fundamentals.”
I know. I know. That statement borders on the verge of heresy but let me explain.
If stock market bubbles are driven by speculation, greed, and emotional biases – the valuations and fundamentals are simply a reflection of those emotions.
In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise. Let me show you a very basic example of what I mean. The chart below is the long-term valuation of the S&P 500 going back to 1871.
First, it is important to notice that with the exception of only 1929, 2000 and 2007, every other major market crash occurred with valuations at levels equal to, or lower, than they are currently. Secondly, all of these crashes have been the result of things unrelated to valuation levels such as liquidity issues, government actions, rising interest rates, recessions or inflationary spikes. However, those events were only a catalyst, or trigger, that started the “panic for the exits” by investors.
Market crashes are an “emotionally” driven imbalance in supply and demand. You will commonly hear that “for every buyer there must be a seller.” This is absolutely true. The issue becomes at “what price.” What moves prices up and down, in a normal market environment, is the price level at which a buyer and seller complete a transaction.
In a market crash, however, the number of people wanting to “sell” vastly overwhelms the number of people willing to “buy.” It is at these moments that prices drop precipitously as “sellers” drop the levels at which they are willing to dump their shares in a desperate attempt to find a “buyer.” This has nothing to do with fundamentals. It is strictly an emotional panic which is ultimately reflected by a sharp devaluation in market fundamentals.
A recent debate between my friend Bob Bronson and Mark Hulbert about “a bubble in stock market bubble warnings” highlights some of the disconnects. As Bob correctly states:
“The primary academic review work does not even attempt to generalize the conditions of all bubbles, or even the investor sentiment aspect of them. They’ve merely identified five metrics – they discuss seven – but there are many dozens more that we track, including new ones that always crop up in new bubbles.
The fact that the factors they studied are only 50% in magnitude this time doesn’t mean other valuation and speculation excesses, whether they have also occurred before, or new ones, like unicorns, don’t make up another bubble today. In fact, our work shows just exactly that and being involved in every bear market during the past 50 years primarily advising institutional and professional investors about them.
It can be most reasonably assumed that market are sufficient enough that every bubble is significantly different than the previous one and even all earlier bubbles. In fact, it’s to be expected that a new bubble will always be different than the previous one(s) since investors will only bid up prices to extreme overvaluation levels if they are sure it is not repeating what led to the last, or previous bubbles. Comparing the current extreme overvaluation to the dotcom is intellectually silly.
I would argue that when comparisons to previous bubbles becomes most popular – like now – it’s a reliable timing marker of the top in a current bubble. As an analogy, no matter how thoroughly a fatal car crash is studied, there will still be other fatal car crashes in the future, even if the previous accident-causing mistakes are avoided.”
He is absolutely right. Comparing the current market bubble to any previous market bubble is rather pointless. Financial markets have already studied and adapted to the causes of the previous “fatal crashes” but this won’t prevent the next one.
George Soros’ take on bubbles is also very important to consider at this juncture. To wit:
“”First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality the markets are far from equilibrium conditions.
Every bubble has two components:
- An underlying trend that prevails in reality, and;
- A misconception relating to that trend.
When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.”
Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions.
The chart below is an example of asymmetric bubbles.
The pattern of bubbles is interesting because it changes the argument from a fundamental view to a technical view. Prices reflect the psychology of the market which can create a feedback loop between the markets and fundamentals.
This pattern of bubbles can be clearly seen at every bull market peak in history.The chart below utilizes Dr. Robert Shiller’s stock market data going back to 1900 on an inflation adjusted basis with an overlay of the asymmetrical bubble shape.
There is currently a strong belief that the financial markets are not in a bubble. The arguments supporting those beliefs are all based on comparisons to past market bubbles.
The inherent problem with much of the mainstream analysis is that it assumes everything remains status quo. However, the question becomes what can go wrong for the market? In a word, “much.”
Economic growth remains very elusive, corporate profits appear to have peaked, and there is an overwhelming complacency with regards to risk. Those ingredients combined with an extraction of liquidity by the Federal Reserve leaves the markets more vulnerable to an exogenous event than currently believed.
It is likely that in a world where there is virtually “no fear” of a market correction, an overwhelming sense of “urgency” to be invested and a continual drone of “bullish chatter;” markets are poised for the unexpected, unanticipated and inevitable reversion.
Take a step back from the media, and Wall Street commentary, for a moment and make an honest assessment of the financial markets today. If our job is to “bet” when the “odds” of winning are in our favor, then exactly how “strong” is the fundamental hand you are currently betting on?
This “time IS different” only from the standpoint that the variables are not exactly the same as they have been previously. Of course, they never are, and the result will be “…the same as it ever was.”
