It was Monday morning, your mind was still stuck somewhere on the weekend, so you started your day by drinking your coffee and opening a news website. Let’s check what has been happening before connecting to the first of many Zoom-calls of the day.
To your surprise you saw a lot of coverage about a certain Ray Dalio that spoke about his bubble indicator. In case you didn’t know who that was, you quickly found out that it’s someone who made a lot of money by betting on macroeconomic events.
Ok, it’s related to my money. What the hell is a bubble anyway?
A bubble is an unsustainably high price over a given period of time. Why unsustained? Well because at some point it will stop and the bubble will burst.
Did this happen in the past already? Yes it has, and will happen as well in the future. Why?
The efficient market theory defines that stock markets are always priced right, because we all have access to the same information, at the same time. However, history has shown an aspect that the classical financial theory had omitted - human behaviour.
People tend to get overexcited assuming that the current favorable economic conditions (e.g. strong growth, low interest rates) will persist in the future. This creates a broad enthusiasm, and more people join this contagious investor excitement. This is commonly known as “herd behavior”. All of this leads investors to interpret increasing prices as a trend that will continue, causing them to chase the market.
Add to that the envy of seeing your neighbour and friends get rich on their stock portfolio and what else can we do then join in.
What ultimately happens is that our assessment of this strong economy ahead of us turns out to be overly optimistic, the bubble bursts and we all know how it ends.
While the result is often the same - prices fall sharply - it is as well important to see how long prices fall. The longer the period, the longer the uncertainty that will reign in the economy.
Let’s quickly look at some historical data points:
Are we in the Dot-Com bubble 2.0?
Now every bubble has its own reasons to burst and its own time to get back to pre-crash levels. The Dot-com bubble is probably the most known one and was caused by the emergence of the widespread use and adoption of the internet for shopping, communication and news amongst others. The frenzy of buying internet-based stocks was so overwhelming that any internet company could IPO as it surely would be a knockout success in the future. As some of these hopes seemed overblown and investors were confronted with some reality in the form of early bankruptcies, they decided to collectively move out of technology stocks and the Nasdaq crashed by almost 80%.
Let’s get to the point, we read a lot about how we are approaching a bubble similar to the Dot-com crash. Back in the 00’s, people were putting their money in companies that had little to no supportive financials and that were barely contributing to the world’s GDP. And all this while investors had interesting return possibilities on government bonds (ten year treasury yielding 6.5%!) and saving accounts, so they were free to not join the hype.
Nowadays, with interest rates to remain low for the foreseeable future, returns available on bonds and cash savings will continue to be neglectable. You can turn towards crypto, but with no interest rate on them, nor fundamentals, it is pure speculation. So it is understandable that equity markets and more particularly high-growing tech stocks have been the favorite place to go. And what about SPACs? Let’s say there are more SPAC funds out there, then they are SPAC-able companies. But this is a general reflection of the excess liquidity that has been in the markets. Investors are chasing for the extra returns wherever they can, and do not hesitate in putting money where they would normally not to.
Another key difference is the definition of tech stocks and their use. As of 2019, the US tech stocks (e.g. Apple, Amazon, Alphabet, Tesla, Facebook and the likes) alone contributed to 12% of the US GDP and indirectly supported over 18m jobs. Those numbers are probably even higher nowadays. This is a very different picture from back in the late 90’s, where tech stocks were a fast-growing segment of the economy, while nowadays they are central to our daily lives.
Interest rates (once more) the elephant in the room
For the first time in the history books, have interest rates been so low for a prolonged period of time. This has of course been welcomed by corporates and consumers alike, as it allowed them to lend money at a cheap cost. However this ongoing loose monetary policy can in theory not go on forever, as you risk to devalue the value of your money (e.g. inflation). in massive inflation. And as we all know it, the only effective lever to against this is to increase interest rates.
What happens then is that businesses will have to pay more interest on loans to finance projects and consumers will be charged more on their credit cards and mortgages. With the amount of cheap debt that has been and is still available, indebted companies will be hoping to avoid a dramatic increase in their debt burden. Now while it’s clear that rising rates, or alone the perception of it, could lead to a stock market correction, at what level of rates remains the uncertainty.
The problem with the current rate environment is that we have never experienced interest rates this low before and governments have never been that highly indebted either.
Balancing the need for persistent low rates to finance a ballooning public debt with the desire to boost economic activity, without overheating things, are the conundrum every central banker is facing nowadays.
But long story short, what does that mean for you as a retail investor?
The most relevant points are the following:
1. Do you know why you are investing?
a. Your securities account is not an ATM, so only invest money that you don’t need in the short-term
b. Are you investing to make short-term profit or to build a financial buffer for the future?
2. Are you comfortable with your current equity exposure
a. How much of your portfolio is in equity? You feel it’s too much, then how about you rebalance. Doesn’t need to be forever!
b. Is your portfolio sufficiently diversified for you? Are you willing to have less returns to be exposed to a lower risk?
Stock markets - and we can debate for days about this - have been designed to grow in line with the population. The more people are able to participate in the economy (by this I mean spending money on Amazon), the higher markets will go. But for this to happen, markets need to fall once in a while, as growth cannot be linear.
As seen earlier on in the article, markets have always recovered, even from the worst crashes, so what matters is to stay long-term in the markets. And unless you have a bead to predict big market movements, this means to stay invested for the long-run across highs but as well lows.
Disclaimer: All investments involve risk, including loss of principal. The contents presented herein are provided for general investment education and informational purposes only and do not constitute an offer to sell or a solicitation to buy any specific securities or engage in any particular investment strategy.