The Boy in the Bubble

There was a bumper sticker in the mid-2000’s that read “If you’re not angry you’re not paying attention.” Well, today, I say to you “If you’re not confused, you’re not paying attention.” Whether it is coronavirus, markets, Fed policy, social and civil unrest, tweets, posts, fake news, skewed news, social media, bio-medicine, technology…whatever it is, how do we know what to make of any of it? We are bombarded with information, unequipped with a “secret de-coder ring”, and expected to understand it. One thing is for certain, it is usually dire, and it’s usually supplied without a solution.

For nearly three and a half months the news cycle has been extremely negative. The old journalism yarn, “If it bleeds it leads”? Well, as a world, we’ve been hemorrhaging like a stuck pig. Just when it appeared, we were breaking the cycle re-emerging from our nests, demonstrations erupted that pushed many of us back inside.

The stock market, since mid-March, has largely looked the other way when it comes to the bad news being reported. To the disbelief of many, the stock market has largely recouped much of the coronavirus rout. This recovery, juxtaposed to the news cycle, has left many of us, me included, scratching our heads. Is the market out of its mind? Aren’t we all watching the same movie? If the economy looks so gloomy, if GDP has potentially witnessed the largest decline since the Great Depression, is it possible that the stock market should be trading near all-time highs? Mind you, these highs, that are close to being re-tested in the S&P 500 and highs and have recently been broken in the Nasdaq Composite, were considered by many, even before the crisis, to be overvalued levels and pushing P/E multiples only eclipsed by the late 1990’s Tech Bubble. Therefore, if those values looked rich in early February with the economy in much better shape than it is today, they must be insanely rich today. So, is it possible to simultaneously be in a severe recession and a stock market bubble?

Bubbles are typically defined by a belief that prices can only go higher, leading many to assume greater and greater risk, under the illusion that there is, in actuality, no risk. As others see people around them making money by taking extraordinary risk, more and more people pile in and push prices even higher. Some may recognize the risk they are taking, but continue anyway, certain that there will always be a greater fool behind them to buy what they themselves are buying. To be a real bubble there needs to be rapid price increases and a rapid increase in participation. Typically, we get glimpses of the insanity in isolated “pockets” but ignore the overall bubble, discounting those “pockets” as outliers.

We witnessed this phenomenon in 1999-2000 in the Nasdaq Bubble and in the 2002-2007 Housing Bubble. In the late ‘90’s it was the rise of online trading and the hype of the internet that pushed prices of tech stocks, along with the prices of nearly every other stock, to valuations of an unparalleled level. When this bubble popped, many of these companies disappeared, many people lost a lot of money, and when it was all said and done, the Nasdaq fell over 75% from its highs. The housing bubble that followed was preceded by generationally low rates leading to easing lending standards and a boom in housing prices. As prices rose each year, and wage levels failed to keep pace, more and more people began to take on greater and greater debt to buy a home. The old rule of spending roughly 3 times your annual salary on a home went out the window and people were assuming mortgage payments well over half their income. Home price to income levels ratios, on a nationwide basis, exploded to all-time highs. As prices continued to rise, many people saw this as an opportunity to make easy money. Those investors jumped in and bought multiple homes certain they would be able to “flip it” as prices continued to rise. When that bubble burst, banks collapsed, people lost a lot of money, the financial system nearly collapsed, and banks got bailed out.

Today, we see some of these same traits re-emerging. For eleven years the stock market had rallied unabated. Fueled by a recovery from the disaster of 2008 and a Federal Reserve policy of perpetually low rates and an asset purchase program unseen in world history, markets rose higher and higher led by technology and growth stocks. In February, the market began to collapse. By mid-March we witnessed the fastest and deepest declines in U.S. stock market history. Officially the bull market was over. However, since the March 23^rd low, the S&P 500 has come back strongly. By Monday, the S&P 500 closed 44.5% higher than its March lows. Technically speaking, bull markets end with a correction of greater than 20%. If the bull market ended in March, then either we are in a new bull market or this is just a big bear market rally.

If this is a new bull market, it would be the first bull market to begin with large individual, retail participation. Usually, large participation by smaller participants isn’t witnessed until the later stages of a bull market, rarely if ever at the beginning. Second, if this is a new bull market then the bear market, we just witnessed, was the shortest on record. Third, if this is a new bull market, it would also mark the quickest bull market to reach stretched traditional valuation metrics. Finally, if this is a new bull market, we should probably expect it to last quite a while longer. I can’t speak to the final point, but the first three points seem extremely dubious.

On the other side, if this a bear market rally it has certainly lasted much longer than most people would’ve expected, not so much in terms of time, but in terms of percentage gains. If this is a bear market rally, it is extremely unusual to see a leading market index like the Nasdaq 100 making new highs. Higher highs are indications of bull trends, not bear trends. These occurrences make it increasingly difficult to classify the last few months as a bear market rally. Is it possible, then, that what we’ve experienced is neither of these two things?

The other alternative is that the 2009-2020 bull market never really ended. That the financial definitions of bull markets and bear markets are really quite arbitrary to begin with. Back to my original question about the reaction of the markets to news events, the market really isn’t a soul-less, form-less entity, it is an amalgamation of people’s opinions and emotions. Granted it is somewhat distorted now because of Federal Reserve policies, but in the end, people drive the market. People are not as consumed by definitions as academics are. A bull market or a bear market rally, one thing that seems to be clear is that there is a tremendous appetite for risk and a large participation by small investors at the extreme end of the risk spectrum.

Much of this should lead to caution from prudent investors. But the prudent usually get dismissed during periods of euphoric price rises. Like a nagging mother, harping on the potential risks, the typical investor goes charging out into the street certain in his own immortality. Bubbles are a fact of markets. Financial loss is a fact of markets and capitalism. We can believe we’ve prevented them, but they will always materialize whether we like it or not.   

Thanks for reading,

Zach and Dave

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