Are We In a Stock Market Bubble?

The stock market is not a synonym to the economy. However, it does help to understand many economic factors. Yet, just like any other economic system, it is flawed. Its deficits appear when we see economic crisis such as the 1929 crash, the 2000 dot-com crash or, more recently, the 2008 crash. We are currently living a crisis that should absolutely destroy the stock market, yet, that is not happening. The question that I am proposing to answer in this article is if we are entering a bubble, similar to the bubbles that we experienced in the years, 1929, 2000 and 2008.

In order to further understand the rest of the article, it is important to comprehend what an economic bubble is. An economic bubble, in a very simple manner, is the moment when assets are priced in excess of their genuine value. To put it simply, it is when the traders trade their stocks not based on the value of a particular stock, but rather on the possibilities that that stock has: its likely future price. The problem with this is that when the bubble pops, there are sudden drops in the market, drops that usually hurt economies. While there is no clear agreement on what causes bubbles, there is evidence to suggest that they are not caused by bounded rationality or assumptions about the irrationality of others, as assumed by greater fool theory. It has also been shown that bubbles appear even when market participants are well-capable of pricing assets correctly. Further, it has been shown that bubbles appear even when speculation is not possible or when over-confidence is absent.

There are some stages that economic bubbles go through. The first stage is the increase of the value of the assets, the second stage is the takeoff of speculative purchases, the third stage is the exuberance when the traders are happy seeing their assets appreciate in the short term, the fourth stage is the critical stage when the sellers start to outdo the buyers and some buyers start to take-profit on their investments. Finally, there is the final fifth stage that is the pop, leading to a crash.

There are nine factors that can help us to identify an economic bubble.

1. Low-interest rate, encouraging people to borrow more

2. Global imbalances

3. Selling subprime debt

4. High media and marketing presence around the assets

5. Asset prices are justified with weak arguments such as “real estate value only goes up”

6. Increased high-risk lending

7. The purchase of an asset is justified with the future possible value and not the current value

8. Most assets are bought using leverage

9. General increase of EPS on the stock market (with a higher Earning Per Share, the trader pays more per each dollar than the company makes)

Now, in order to understand if our metrics are not flawed, we must compare it with each major crisis, that resulted after a bubble, 1929, 2000 and 2008.

The Great Depression of 1929

The Great Depression was the worst economic crisis to this day with the GDP of the US falling 30%, the stock market losing 90% of its value and the unemployment rate peaking at 24,9%. The causes of the crisis were an economic bubble. Using the factors that I have shown you, the Great Depression, before the pop of the bubble, saw the interest rates very low. Predicting the crisis, the interest rates were raised in 1928 and 1929, however, unsuccessfully.Global imbalances were also clear. After the WWI, by 1926, major countries got back to the gold standard. Where the countries held reserves in Dollars, Sterling and Francs, and the United States, Great Britain and France held gold. But this system had some serious flaws which prevented that the imbalances generated were adjusted smoothly. Real exchange rates were misaligned, and the system began to lose credibility. Banks, in order to make more money, started to lend money to people that could not pay the lender back. The banks then started to sell subprime debt so that they could get rid of debts. Investing in real estate was a very popular investment because people really believed that the prices could not go down. They had good reason to believe so since the prices went up 62% up to 1929. They did, however, fall 51% of their value by 1933. Most assets were bought using leverage. The EPS during the bubble were very high as well. As we can see, every single metric is checked in the 1929 crisis.

Dot-com Bubble of 2000

The dot-com bubble is a very good example to understand. Bubbles do not have to be general. It can be industry-focused. In this case, it was the rise of the internet. The NASDAQ Index rose more than 500% from 1995 to the peak in March 2000. This bubble also checked all the boxes. The increased spending and lending by the people and banks, respectively, sell those subprime debts to third parties. The thought at the time was that it was more important to grow in order to cash in the profits later. Therefore, companies were constantly in debt and their assets were being priced at their future price instead of their current price. The media coverage was very high on the internet and the EPS was very high for the real value of each stock.

(Yellow line is the S&P 500 Index and Red line is the NASDAQ Index)

Great Recession 2008

The Great Recession is the best example to explain what a bubble is. It started as a real estate bubble, but it rapidly turned to be much bigger than that. The 2008 crisis speculated on the real estate prices using those weak arguments that were mentioned prior: “real estate prices cannot go down”. Banks realized that they could make more money by allowing anyone to get a mortgage and then sold the bad investments as if they were good. This was also done due to very low-interest rates. The majority of assets were bought with leverage and that soon became unsupportable. Again, this is the perfect example because it checks every single box.

(Black line is the DOW JONES Index, Yellow line is the S&P 500 Index and Red line is the NASDAQ Index)

We have a clear understanding that these metrics are in fact, correct and true.

2020 Reaction of the Market to the Pandemic

The initial reaction to the health crisis was ignoring it. It was only when the virus reached Europe that the markets started to fall reaching a year low on March 23rd. However, the market soon disregarded the virus and the value lost went back up. The NASDAQ Index, for example, not only raised but to an all-time high, in the middle of a Pandemic that still does not have a cure and has killed more than half a million people worldwide. The other two main indexes have a negative balance of 1.8% and 9.5%. Again, we are in the middle of a world pandemic. Align with that, the unemployment rate in the United States has risen to the incredible levels of 11%. Other shocking news that has been reported is that one-quarter of the Americans could not pay their housing bills in April. This has since risen to 30% in June. This is a very serious trend. The economy might collapse if it does continue.

(Black line is the DOW JONES Index, Yellow line is the S&P 500 Index and Red line is the NASDAQ Index)

Also, you have to think that the government has been using helicopter money. The US government cannot, however, do that forever. The stock market has also been rising. Some index and stocks are even higher than the very high levels that we had prior to the pandemic. The main goal of a trader is to buy low and sell high. In this market, it has been very difficult to find good deals. Warren Buffet, for example, is not investing any of his money. Most big investors are with him. So, if we do not have good deals, and no major investor is investing, who is buying in this market?

Coronavirus Crisis compared with the metrics 2020

High-media attention to this has been a constant around this crisis. The market’s EPS has been extremely high, as I said before, and finding good deals is nearly impossible. With that, Global imbalances have also been very high and around levels that were reached in the Great Recession. The subprime lending and subsequent selling of those debts are starting to rise, however, it is currently at controllable levels. The interest rates are at an all-time low. Some banks even have negative interest rates. We still do not have enough, credible, data to say that most assets are being, or are not being, bought using leverage, yet, the arguments used to purchase such assets are very weak and based on the future value of a company rather than their real value. Examples of this can be Tesla (TSLA) or Nio (NIO), the electric car makers that have been skyrocketing despite analysts predicting both companies will lose money this quarter.

Are we in an economic bubble?

Well, although I believe we are, we still do not have enough data to say so. The coronavirus crisis has checked most boxes, yet not all. It is very important to explain that to predict or understand the moment of a bubble is a very hard thing that most economists have struggled with. This article is not an investment advisor and you should not base your investment with what you read here.

The Politician Independent Newspaper, created in 2020