Just How Frothy Is The Stock Market?

Authored by Bill Blain via MorningPorridge.com,

As 25,000 UK retail workers get set to join the dole queues – the stock market remains in party mode. Not right is it? Now that bond yields have been repressed to nothing, it’s unsurprising the money is flowing into Stocks from Fixed Income. Investors will do anything – literally anything – for the sake of returns – which stocks may or may not provide (rather depends on what the Global Economy does.) November was a record month for Stocks and December looks on a roll. Forget global recession, the pandemic, and trade wars. Markets look like motoring through to a jubilant new year. Yesterday it was a story about $81 bln going into stock ETFs.

The market’s mood to justify the rise is to assume every-thing is golden – any old stock with any kind of improbable prospects is suddenly a potential winner as we “rotate” into fundamental stocks producing real income, and stocks trashed by Covid which will Phoenix-like fly (or float) again. To my jaundiced eye… it all looks very bubblicious. What is really going on in Stocks?

Ask a bull and they will tell you underlying stock strength is due to the vaccines, the end of the pandemic on the horizon, repressed consumer spending, the likelihood of ongoing global stimulus, and that momentum means stocks are going higher. 

Ask a bear and they will quote you the Peculiar Madness of Crowds, the unsustainability and froth, rising debt, risks and bubble conditions. 

Ask a realist who actually understands markets, and they will agree with elements of both perspectives, but explain the real issue is the long-term distortion on prices caused by ultralow rates and ongoing policy implications. Too much money chasing too few assets (exactly the situation in stocks) will always push up prices. We’ve come to accept runaway stock prices despite the current pandemic recession. It’s called Financial Asset Stagflation! The reality is market distortions are the dominant force driving stock prices higher… and that’s difficult to accept when you believe stocks represent fundamental value at these levels.

Nope. Stocks are massively overvalued. Bonds are massively overpriced. But they are likely to remain there for a while yet because of ongoing policy distortions.

That belief markets can’t go down because of distortions is now firmly embedded in the mindset of markets. 

But dangerous beliefs always have consequences.

The laws of financial gravity are immutable. There is a relationship between global wealth, growth and the value of stocks and bonds (financial assets.) There is balance that sets risk/reward returns. These are all out of sync at present – stock market values are out of all proportion to global growth prospects, while investors are now being forced to accept ever greater risks for lower returns.  Distortions can only last so long before reality bites and overcomes – often violently.  

Central banks, QE infinity, government stimulus and ultra-low rates are pump priming the “Bubble Triangle”. It’s at its clearest in the peculiar price madness around stocks like Tesla and the confabulation that is Bitcoin, but the whole market is heading towards an ecstatic bubble dénouement. 

Market behaviour is a curious thing. The market responds predictably to the stimuli it receives. The forces that make demand for a commodity or a financial asset go up and down are understandable: you can predict how much copper wire will likely be needed and you how much is available; demand and supply. You trust the authorities to regulate the market to ensure it is honest, transparent and fair.

But you can’t rationalise the psychology and behaviour of crowds to these stimuli. Economists have tried to rationalise expectations – it doesn’t work. The madness of investors is infinitely surprising. Markets are not rational – the are reflections of beliefs driven not by uncommon common sense, but largely by the hope of returns and profits. (The level of hope tends to move inversely to the strength of the economy.) As I’ve written so many times.. Hope is never a Strategy. 

We have a whole host of factors fuelling bubbles at present:

1) The belief markets will be kept indefinitely high by central bank and government distortion, 

2) The belief that tech stocks are changing the narrative – bubbles always thrive in times of invention and innovation that nurture hopes of extraordinary future profits. 

3) The surge of new participants into stocks – not just the retail “RobinHoods” but also professional and institutional investors being forced into more risk market niches. 

There is a great new book Boom & Bust; a global history of financial bubbles, which describes the Bubble Triangle: 

  • Marketability of the asset – Legality, markets, size of market, divisibility, 

  • Money and Credit – What fuels the bubble? Relative returns, FOMO, low rates

  • Speculation – The snake oil story, the belief in “momentum”, the absence of financial gravity, a “this time it’s different” mentality, and an increasingly unshakeable belief “prices are always going to go up”. 

The authors warn the most dangerous bubbles are those driven by policy. (Your internal alarm bells should be screaming at this point.) There has never been a period in the history of the capitalist west where policy has been this critical for driving up the price of the stock market.

That is why this is such a “danger, danger Will Robinson” moment.

The fact the soon-to-be-ex-US President didn’t understand that prices were being driven higher by policy – and assumed it was all due to his personal financial acumen – is revealing just how much in denial folk are about the current monetary distortions. 

I don’t think there is a single rational investor on the planet that thinks Tesla is cheap. It’s a bunch of vaguely connected, small sub-optimally sized operations that have been spun into a world-changing visionary dream. It’s worth a fraction of its current market cap and most folk get that. But many will still trade it – anticipating there will be a final Greater Fool set to jump in on the assumption it will go yet higher. It’s a dangerous game of pass the parcel where last man holding gets blown up. 

Bitcoin is more confusing. That bubble has burst before, but it keeps coming back whenever the market looks dark enough. Its founded on a series of lies that it will replace gold and currencies and you can’t afford to miss it. Each time more people seem to be sucked in, reinforcing the myth that acceptability makes it credible. They get sucked in because they are either desperate, or they see others getting rich and FOMO (Fear of Missing Out, the most powerful financial force on the planet) takes over.

Playing these bubbles can be a very satisfying financial strategy – spotting a bubble forming, getting in and knowing when to get out is extremely skillful. A really great bubble becomes a self-reinforcing perpetual motion machine, attracting more and more money the higher it goes – right up to the moment it pops. 

What will cause the current bubbles to pop? 

I suspect it could come next year when the pandemic is over, and the debate about costs ratchets up. As economies recover, stimulus cheques will be pulled and its possible we’ll see signs of inflation, causing central banks to dare mutter the “tighten” phrase at which point the bond market will go to hell in the proverbial handbasket. And that will roll round markets – and create a fantastic unmissable buying opportunity…

You wouldn’t want to miss the start of the next bubble would you? 

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