Ed Peters
February 9, 2021

Market pundits have been talking bubbles lately. The broad market appears to be overvalued by many measures. The recent volatility involving GameStop and silver have increased talk of bubbles. But exactly what is a “bubble,” and can we only identify one in hindsight?

In the aftermath of the Dot-Com Bubble, I came up with the following checklist of characteristics common to financial bubbles. You can find a more extended description of each in a more thorough discussion here. Going through these items, it appears that we are heading for an asset price bubble, but we’re not quite there yet, even if the market is overvalued. So, let’s go through the checklist and you can decide whether you agree!

1) Low interest rates and excessive leverage. Verdict: Check.

Every asset price bubble in the past occurred when interest rates were low, and we definitely have low interest rates. Low interest rates can lead to excessive buying on margin, a leveraged state Hyman Minsky called “Ponzi finance.” Credit to GDP ratios confirm that leverage is currently higher than average. But leverage alone is not enough for a “bubble.”

2) Significant economic innovation and productivity gains. Verdict: No.

Innovation is good, right? It is, but it can also lead investors to ignore historical norms for valuations. The internet served this function in the tech bubble of the late 1990s. In the 1920s, it was electricity. In 2021, we haven’t seen a technological change of that magnitude. So the “this time things are different” mentality hasn’t really developed yet and there is a healthy nervousness about high valuations.

3) Innovations in securities markets. Verdict: Check.

There are a number of current examples, including app-based trading, zero-commission execution, and social media cooperation. In previous bubbles, similar innovations occurred. Online trading became available during the tech bubble, and in the 1920s, wireless telegraphs allowed investors to trade even if they were cruising the Atlantic.

4) Mini-bubbles develop. Verdict: Check.

Mini-bubbles are a symptom of a growing bubble mentality. We continue to have speculation in IPOs and cryptocurrencies, as well as select stocks. These assets have mostly gone to unrealistic heights based upon pure crowd behavior. In the 1920s, there was a run on any company that said it was going to produce light bulbs. In the 1990s, there were several unusual bubbles, including one on “Beanie Babies,” where people were willing to pay up to $5,000 for a toy that retailed for $5. And, of course, in the tech bubble, any company with dot-com after its name sold for high values during IPOs. It’s a familiar narrative, which we’re seeing again: Companies with little history and no profits selling for high prices based upon a widely accepted story.

5) Moral Hazard: Investing is easy, downside is limited. Verdict: Not yet.

While there are signs of moral hazard developing, it has not yet achieved levels that define manias. During a bubble, there is widespread belief that the market can only go up. There is also belief that since markets go up in the long term, so you should always buy the dip. When these views are broadly shared, an overvalued market transitions to a cultural phenomenon which we call a “bubble.”

The aggressive stimulus by central banks to support the market could reinforce the impression that equity risk is always low, as could isolated stories of “get rich quick” experiences in the retail market. While the IPO market is similar, we’re not seeing this kind of mania on a wide-spread basis. At least not yet. 

Conclusion: Bubble developing but not yet fully inflated.
Moral hazard is really the culmination of the other items on the checklist and necessary for a “bubble.” While we have checked three of the first four boxes, we’re not quite there yet. That doesn’t mean the markets can’t have a meaningful correction at this point. In fact, a quick market recovery from another leg down may create the moral hazard that is the final stage of a bubble. The market may be overvalued, but a bubble is a cultural phenomenon, and 2021 does not yet qualify in my opinion. Let’s hope it stays that way.

Past results are not indicative of future investment results. Commodities trading involves substantial risk of loss.
© First Quadrant, L.P. 2021. Intended for Institutional and Qualified Eligible Persons Use Only. The views expressed are the views of First Quadrant, L.P. only as of the date shown and are subject to change without notice based on market and other conditions. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice, recommendation, or solicitation of any particular security, strategy or investment product. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of domicile. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

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