My friend Bill Bernstein has written a splendid book on manias, financial and otherwise, entitled The Delusions of Crowds. He invokes four conditions that he cites that historically have preceded investment bubbles. I apply those precepts to the current U.S. stock market.
1) Lower Interest Rates
This item and the next owe to observations from economist Hyman Minksy, who emphasized the fallibility of the invisible hand. Minsky regarded the financial markets as inherently unstable, progressing from overly cautious to appropriately bold to distressingly speculative to eventually collapsing, at which point the cycle repeats. The third stage is fueled by reductions in interest rates, which create easy money.
We are certainly in that position today. Money could not be easier unless the government were to give it away, which, with a Federal Funds Rate of 0.09%, the Treasury is perilously close to doing. (Come to think of it, this spring’s CARES Act did disburse cash.)
2) Emerging Technology
When new technologies are believed to offer revolutionary benefits, investors disregard the traditional measures of value. The old rules, they believe, apply to a world that no longer exists.
That belief has become familiar. Trading at 15x revenues and 100x its expected earnings, Tesla is the shiniest example of a stock that has benefited from confidence in the power of scientific advancements; but in that aspect, it is joined by many of the S&P 500’s leaders. Clearly, the current U.S. equity marketplace expects great things from recently developed technologies.
3) Investor Amnesia
As Bill points out, Minsky’s cycle won’t operate if investors have been chastened by previous crashes. Either they must be too green to have suffered through a financial meltdown, or they have banished such traumas from their memories.
Whether that precept applies today is uncertain. It obviously does to Robinhood’s youthful clientele; with a median age of 31, the typical Robinhood customer was but a teenager during the 2008 global financial crisis. However, most equity assets are managed by much older investors. One would think that they still recall 2008’s carnage. However, this year’s rapid recovery from what initially appeared to be a nasty bear market might have dispelled such concerns.
4) New Math
If investments aren’t expensive, they are not foolish. They might be highly risky--for example, the stock of a leveraged company that is attempting to survive a recession, while facing better-capitalized rivals--but if securities are reasonably priced, they can be sound choices for well-diversified portfolios. What makes them indefensible are unsustainable valuations, supported by arguments that changing economic conditions require a new form of investment math.
Here, too, the evidence is mixed. To be sure, U.S. stocks are costly by any traditional measure, supported by dingbats who claim that economic changes may have changed the equations.
However, while the S&P 500’s PE and PB ratios currently exceed their pre-1995 levels, they aren’t remarkably high by the standards of the preceding 25 years. If current U.S. stock values indicate an investment bubble, then so have several other values during the past 25 years.
These days, Bill’s four boxes have been largely checked. Without doubt, interest rates are low, money is easy, and investors have placed an abiding faith on new technologies. It is less clear that they have suppressed 2008’s lesson, or that U.S. stock prices have crossed the line that separates bold from speculative, but both outcomes are possibilities. The bubble appears to have been established.
The 4 signs
In addition to the prerequisites for forming a financial bubble, Bill provides “subplots” that reveal the extent of the contagion. Normally, investments interest only the wealthy, but during the late stages of bubbles they cross socioeconomic barriers to become national preoccupations.
1) Conversation Starters
Bill writes that first and foremost, financial speculation begins to dominate all but the most mundane social interactions; whenever and wherever people meet, they talk not of the weather, family, or sports, but rather of stocks and real estate.
2) Amateur Hour
As stories of newly minted wealth abound, people increasingly quit their jobs, intending to make a better living by “speculating in the aforementioned assets.” They become the modern-day equivalent of gold prospectors.
3) Angry Bulls
Investors grow emotional about their purchases, into which they have poured so much of their future hopes. They become scornful of those with different views, if not outright hostile. Their investments become politicized.
4) Future Shock
As the bubble expands, thereby permeating the minds of investors so thoroughly that they cannot imagine any other reality than this being the best of all possible times, participants “begin to make outlandish financial forecasts.”
Wrapping Up
These were all familiar events during the late 1990s. At that time, I downplayed my occupation when meeting strangers, so that I wouldn’t be dragged into investment conversations. Some people became day traders. Morningstar’s bearish technology analysts received death threats. And a July 1999 investor poll found respondents forecasting a 17% stock market gain over the next 12 months.
However, they are not much in evidence today. I can safely divulge my employer. To my knowledge, Robinhood’s customers invest on the side, not for a living. Morningstar’s equity analysts aren’t treated so harshly. And in a summer 2020 poll, investors expected an 11% annualized return from equities. (Still too optimistic, but considerably less than during the heady days of the New Era.)
Thus, I would say that as bubbles go, the U.S. stock market is in the early stage. That doesn’t mean that equity prices will continue to climb. For all I know, the bear will arrive tomorrow. If so, though, that decline would represent business as usual--the losses that occur when financial markets get ahead of themselves. For a true implosion, the investment news will need to become even better, before it becomes even worse.
