The Australian market this month has reached record highs, fully sealing a market recovery from the March 2020 low amidst covid-19 panic and lockdowns. And as the market continues to climb, thumbing its nose to negative economic data, it has prompted an increasing number of people to ask “are we in a bubble?”.
And because people are asking the question, experts are beginning to respond. I hesitate to say experts are giving the answer, because as yet, we don’t know what the answer will be. All we can do is use the data available to us, assess what has happened in similar situations in the past, and make our best estimate. Really, that’s what investing is: using imperfect data to make decisions about the future.
In this article I’ll take a look at what some of the experts are saying and attempt to form our own view.
Jeremy Grantham
Jeremy Grantham is the founder of GMO, a global investment house, and currently serves on their Asset Allocation Team. He made headlines earlier this year when an article he wrote went viral, calling the current market one of the greatest bubbles in history. He believes that sooner or later a time will come that it will have been better to be out of the market.
He points back further than the current strong run from March 2020, looking at the long-term gains since 2009. He states that for the first 10 years of this current bull run we did not have wild speculation. But in late 2020 and 2021 it is now apparent, seen at various times in the stock trading of Kodak, Hertz, Gamestop, AMC Cinemas, not to mention retail favourite Tesla.
Other indicators he spoke to included
- A record high market cap to GDP ratio – a favourite indicator of Warren Buffett – which broke through 2000 record
- High levels of initial public offerings (IPOs). The US had 480 IPOs in 2020, including a mind boggling 248 SPACs (special purpose acquisition companies; blank cheque companies where management take investments to go out and acquire something yet unknown). This is more IPOs than in 2000, the height of the tech bubble, which had 406 IPOs.
- 150 US companies over a market cap of $250m tripled in 2020, more than the preceding decade.
- Small retail options purchases (less than 10 contracts) increased 8-fold in 2020. Options are used to bet on the direction of a share price.
- The market P/E is close to all-time highs while economic conditions are near all-time lows
In each of the previous bubbles we had reasons that suggested the current one would not end yet. Grantham articulates that the reason this time around is that interest rates will remain near nil forever.
Michael Burry
More recently, Michael Burry, who was made famous for betting against the 2007 housing bubble, and immortalised in Michael Lewis’ book-cum-movie The Big Short, has also called the current market conditions “the biggest bubble in history“.
Burry points out that the level of debt in margin loans in the USA has exploded this year, increasing 47% to $861bn in the last 12 months.
Burry suggests that a lot of the mania is focused on cryptocurrency, a fact that does not take a genius to see. Not only did Bitcoin run to over $60,000 per bitcoin, coins with zero use case like Dogecoin ran to a total market cap of $75bn based on tweets from Elon Musk. More importantly, he says that the crypto bull run is being fueled by large amounts of leverage, which could be savage if the price continues to drop.
The cryptocurrency world is not regulated, which has allowed some crypto brokers and exchanges to offer traders 100-1 leverage for their investments (meaning, for a $1,000 outlay, and investor could buy $100,000 of bitcoin). Margin loans are not unique to cryptocurrencies, but the lack of regulation is. This sort of behaviour certainly has the hallmarks of a potential bubble.
It should be noted, however, that Burry did not say the entire market is in bubble territory, limiting his remarks to certain pockets. This is important.
Ray Dalio
But not all believe we are in bubble territory. Billionaire hedge fund manager Ray Dalio, who is Chief Investment Officer at Bridgewater Associates in New York, has gone to the trouble to develop a bubble indicator, identifying 6 questions to ask, that describe traits that previous bubbles have exhibited. These 6 questions are:
- How high are prices relative to traditional measures?
- Are prices discounting unsustainable conditions?
- How many new buyers have entered the market?
- How broadly bullish is sentiment?
- Are purchases being financed by high leverage?
- Have buyers made exceptionally extended forward purchases to speculate or protect themselves against future price gains?
Using proprietary methods undisclosed, Dalio provides the following table to summarise Bridgewater’s analysis:
Source: Bridgewater Associates
If we take each of these in turn and apply it to the market:
- The Australian All Ordinaries Index currently has a forward P/E of 19.7x (see chart); high by historical standards, but this also must be weighed against interest rates, which are low by historical standards. The average P/E for the All Ords is 16x, so 19.7x does not feel like we are in bubble territory yet. Similarly, the S&P500 is on 22x compared to an average of 16.7x. While high, this doesn’t feel like a bubble. Dalio agrees but says emerging tech is approaching.
Source: Factset
- The stock market as a whole looks to the future to price equities a burgeoning stock market will suggest optimism. This question relates to discount rates used in valuing equities; the lower the discount rate, the higher the valuation. Discount rates used are presently lower than historical because of low interest rates, which feed into the discount rates. The answer to this question may be yes if we were seeing perfect economic conditions and high valuations on stocks, and while the Australian economy has recovered well out of the depths of the coronavirus crisis, it is by no means roaring, nor is this being extrapolated infinitely.
- In Australia and the US, we have indeed seen a large influx of new retail investors entering the market with platforms such as Robinhood, Selfwealth, and other online brokers reporting strong numbers of new customers and long wait times. Research done by Investment Trends estimated that 435,000 new investors entered the market in 2020, representing growth of 35%. The case is even clearer when you include assets like cryptocurrency. These investors have tended to gravitate towards names such as Tesla and Afterpay so I would agree with Dalio’s assessment.
- We can assess broad bullishness based on observations of how some investors are willing to part with their money. When a company can raise money at IPO for an as yet unknown acquisition (what SPAC companies do), this suggests to me a sense of broad bullishness with a market too many funds with and enough places to invest it. Note, the SPAC craze is only apparent in the US market, as we have yet to see this in Australia.
- I noted above that margin loans are at all-time highs and that high levels of leverage is being used to buy cryptocurrency. Dalio points out that options are also being used extensively, especially to buy bubble stocks.
- Forward purchases indicate whether businesses in general expect periods of strong demand to continue. Dalio’s read on this indicator was the weakest of all 6 and ABS data tends to back this up in Australia. While we have seen an increased level of mergers and acquisitions, capital expenditure in the March 2021 quarter only rose 6.3% on the December quarter and 0.8% on the prior March 2020 quarter. Expenditure on private buildings and structures actually fell compared to March 2020, while equipment, plant and machinery grew 9% on December and 5.6% on March 2020.
Dalio suggests that there are certainly parts of the market that is in bubble territory, but according to his analysis, the percentage of the top 1000 US companies and the S&P 500, only 5% and 3% respectively, are likely in a bubble.
Source: Bridgewater Associates
Summing Up
Grantham, Burry, and Dalio are all heavyweights in the investment industry and their opinions should garner our respect. All are using observations on the current market conditions and came to somewhat different conclusions. However, there is one common thread among all their observations, which I think is the key takeaway. That takeaway is that while the market itself might not be in bubble territory, and I don’t believe that it is, however, there are pockets of the market that almost certainly are.
Grantham pointed out a handful of stocks that reached insane levels. Hertz surged 825% when it announced it would file for bankruptcy last year and Kodak increased over 1400% when it announced it had received a loan to fund production of ingredients that go into covid-19 vaccinations. Neither of these lasted long but the mania was indicative of investors’ appetite and fear of missing out.
Even though bitcoin has halved, it is still up over 300% since January 2020. Dogecoin, launched as a joke in 2013, reached a total valuation of $70bn this year after rising over 14,600% since January 1. Dogecoin has no value or use case and yet speculators piled in, hoping to simply sell their coin to someone else for a higher price. Dogecoin is still up almost 500% since January. Other cryptos tell a similar story. And then we have emerging tech, which might include (but is not limited to) companies such Tesla, and Nikola or the Buy Now Pay Later sector in Australia, which each tick most of Dalio’s boxes.
So, are we in a bubble? We don’t think so, and we remain invested at normal levels. But it is clear that pockets of the market are certainly in clear bubble territory, and it is those sectors that will intend to avoid.
Written By Luke Durbin
Oracle Australian Equities Portfolio Manager
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