Is the Stock Market a Bubble?

Is the Stock Market a Bubble?

The stock market has come roaring back since its low in March 2020, where the S&P 500 dropped roughly 30% over the course of a month.

Market Commentary

The stock market has come roaring back since its low in March 2020, where the S&P 500 dropped roughly 30% over the course of a month. From that point, it took only about 4.5 months for the market to return to its pre-Covid level. In the latter half of August 2020, the S&P 500 had surpassed its previous all-time high back in February 2020. This drastic turnaround is one of the fastest recoveries the S&P 500 has seen. For some perspective, the financial crisis that bottomed out in February 2009, took 4+ years for the market to recover to its pre-crash value. With that said, let’s take a brief look at some potential warning signs that are in the market today.

Financial Crisis of 2007/2008

The financial crisis that shook the world in 2007/2008 was due to a host of things, but one of them was the wide availability of credit/money and the abuse of derivative and leveraged products.

Most people would say that the ability to be able to finance a home purchase through a financial institution like a bank or credit union is a good thing. However, when loans are being freely extended to a host of people who are not sufficiently equipped to pay them back, this creates a problem. Some banks nearly failed during the 2007/2008 financial crisis (Lehman Brothers did). Banks other than the one that originated the loan were damaged, because they had bought derivative products that gave them exposure to the subprime real estate market. This of course contributed to a bubble that shook the market.

The interconnection and risks between these mega institutions remain largely the same.

In today’s market there is a large slew of leveraged companies that have access to more capital than ever. Two hedge funds in particular – Archegos Capital Management and Melvin Capital – have both been hammered by massive losses due to their over exposed positions. First Melvin Capital lost roughly 50% (billions of dollars) in January 2021, while Archegos Capital Management lost $8 billion+ on their investments. These losses are important, because it shows that there is high risk taking (even for a hedge fund) that can lead to losses that also effect the various banks that back them. In particular, Credit Suisse and Nomura took substantial losses for being the prime broker for their involvement with Archegos. Though the catalyst of banking trouble in 2007/2008 differs from today, we believe the interconnection and risks between these mega institutions remain largely the same. It appears that leverage levels in today’s market may be approaching a tipping point.

Financial Crisis of 2007-2008

The Number of New Investors is High

Something that we believe is key to determining the market’s climate is the number of new investors that have entered it. There are a number of people who have received stimulus checks over the course of the last year. Those who really need the money will spend it on things like rent and utilities, but what about those who are not in dire need of the money?

Some might spend, and some might save, but we believe that a lot of people threw that money into the market. The more investors are bullish (think the market will go up), the more likely they are to buy companies that may already be at or above their intrinsic value. This can exacerbate the market and be a contributor to a market bubble. Unfortunately, this also means that when those same people get spooked by the market or are in need of cash, they will likely sell out of their positions at an inopportune time. With companies like Robinhood and others making it easier than ever to invest, this brings the potential for a number of unsophisticated investors to join the market. This is problematic, because they tend to enter into the market towards its peak and as mentioned, will sometimes make irrational decisions.

IPOs are Everywhere

The number of IPOs usually spike right around a crisis or potential recession. In the investment world, there are two key terms that keep the balance. They are risk and reward. When people get infatuated with potential reward, they also tend to lose sight of potential risk. We believe this may be taking place in the IPO market. In this case, the comparison is between today’s market and the dot-com bubble that took place in the early 2000s. The dot-com bubble saw a slew of technology stocks rise significantly, only to have a number of them exit the market through bankruptcy. Today’s market, similar to the early 2000s seems to be characterized by an exorbitant number of companies taking to the public market at prices that may be overvalued. The one thing that throws a bit of a wrench in all of this, is that there is an increasing number of companies going public via SPAC.

As you may recall from one of our previous write ups, these blank check companies generally have no form of operations and often seek to merge with another company to take it public. Because the initial phase of a SPAC doesn’t usually have operations, it is hard to say if the total number of IPOs in the market is somewhat diluted. That said, the number of IPOs is high and seems to be at a level similar to the dot-com bubble.

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So, We are in a Bubble?

A lot of what has been said makes it seem like the market may be due for some sort of correction, though we are not sure. There are certainly some warning signs that are evident – higher use of leverage, lots of new investors, people seem overly bullish, numerous IPOs, etc. – but we don’t think this is enough to constitute a full blown bubble. Prices have been rising; however, we do not believe this means companies have extreme overvaluation.

Though it is likely that a bubble is at least in its formation phase, we still believe that there are drivers that could push the correction out another year or two. Some drivers are the continuation of government spending and the Federal Reserve’s commitment to low interest rates. We have already talked about the rounds of stimulus checks that have come out, but now there is also a large bill that is proposed for infrastructure spending as well. In theory, the more money spent on public works, the more potential there is for job creation and a higher general standard of living as well. Couple this with the FED keeping interest rates low – allowing for companies to borrow money for cheap – and you get an economy with growth potential. With vaccines rolling out for Covid-19, we believe this is a good reason to see the economy grow as well, at least in the short term. We also have to take into account that there are sectors of the market that are nowhere near recovered from Covid-19, while there are others thddat have seemingly benefitted from it. The servicing and traveling industries in particular were hit hard, while technology companies like Zoom and Shopify have soared. If there is a bubble, it stands to reason that it may be in a portion of the market, rather than as a whole.

In conclusion, it is just too hard to say if we are in a bubble or not. By our reasoning, there seems to be some formation of one, though we also believe that there is not enough compelling evidence to determine when and how it will pop.

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This material is being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific product, strategy, or service.
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