The latest readings from the “bubble indicator.”
As you know, I like to convert my intuitive thinking into indicators which I write down as decision rules (principles) that can be back-tested and automated to put together with other principles and bets created the same way to make up a portfolio of alpha bets. I have one of these for bubbles. Having been through many bubbles over my 50+ years of investing, about 10 years ago I described what in my mind makes a bubble and use that to identify them in markets—all markets, not just stocks.
I define a bubble market as one that has a combination of the following in high degrees:
- High prices relative to traditional measures of value (e.g., by taking the present value of their cash flows for the duration of the asset and comparing it with their interest rates).
- Unsustainable conditions (e.g., extrapolating past revenue and earnings growth rates late in the cycle when capacity limits mean that that growth can’t be sustained).
- Many new and naïve buyers who were attracted in because the market has gone up a lot so it’s perceived as a hot market.
- Broad bullish sentiment.
- A high percentage of purchases being financed by debt.
- A lot of forward and speculative purchases made to bet on price gains (e.g., inventories that are more than needed, contracted forward purchases, etc.).
I apply these criteria to all markets to see if they’re in bubbles. I have periodically shown you these for stocks and the stock market.
What Was Shown in January and What Is Shown Now
I will first describe in words and then will show in charts the picture and how it has changed since January, when I last shared an update of the bubble indicator.
In January the bubble indicator showed that a) the US equity market as a whole was at the edge of a bubble but not in an extreme bubble (i.e., 70% of the way toward the highest bubble, which happened in late 1990s and late 1920s) and b) the emerging tech companies (e.g., Tesla and Roku) were clearly in an extreme bubble. I also noted that other bubbly behavior (e.g., SPACs, the IPO boom, the big pickup in options activity) financed by the unprecedented flood of liquidity post-COVID had found its way into the asset markets, making things bubbly. I showed which stocks were in bubbles and created an index of those stocks, which I call “bubble stocks.”
Since then, those bubble stocks popped. They declined by about a third over the last year—while the S&P 500 is about flat. With those and other developments in the market—e.g., meaningful decline in frothy retail activity, meaningful deterioration in sentiment, and more—the emerging tech stocks no longer appear to be in a bubble, but neither do they appear to have substantially swung to the opposite extreme, so it’s not necessarily true that now is a good time to buy them.
Bubbles can take a long time to unwind (two years in the case of the 1929 bubble, one year in the case of the late ’90s tech bubble) and typically go to the opposite extreme, so just because they aren’t at a bubble extreme doesn’t mean they are safe or that it’s a good time to get long. In fact, US stocks in aggregate still look overvalued by our measures. History shows that once the popping begins, bubbles more often overcorrect to the downside versus settling at more “normal” prices.
The following charts paint the picture. The first shows the bubble gauge/indicator going back to 1900 for the US equity market as a whole—currently at the 40th percentile. The charts also zoom in on the gauge over the last couple of years, along with the late 1920s bubble and the late 1990s bubble (during both of these cases the gauge reached 100%).
