Are there Market Bubbles? What we can do with it?
Date: February 24th, 2021
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To stabilize the economy during the pandemic, the U.S Federal Reserve utilized fiscal policy and monetary policy. In January 2021, the Fed Reserve announced that they would maintain a low-interest rate at 0.25% and continue to increase its holdings of Treasury securities until the employment rate and inflation rate reach its maximum level. The CPI in January 2021 was 0.3%, which was considered lower than the target inflation of 2%. Note that CPI is known as a laggingindicator of the economy, and it can potentially underestimate the inflation situation since it ignores the substitution effect. In a low-interest-rate environment, Individuals and businesses can borrow to manage their financial situation. On the flip side, individuals and businesses are prone to increase their debt leverage, which can increase the risk they face.
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GDP growth rate VS. Stock market growth
In addition, compared to an average GDP growth rate of around 2.5%, the stock market growth rate is more than that. One of the reasons explains why the U.S stock market skyrockets under a contracted economy is the stimulus checks provided by the government. It is distributed regardless of the employment and financial situation. According to Envestnet Yodlee, a software company, a part of the stimulus check is spent on opening stock and trading accounts.
It is dangerous when the investors only look at the upward slope in the stock market but forget about the hidden economic situation. A similar case can be found in the 1920s market bubbles. The duration of 1920s market bubbles lasted for 6 years, from 1923 to 1929. The economic growth was 50% in 6 years while Dow Jones Industrial Average increased 500%.
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High risk preference
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The panic/Euphoria model built by Citigroup below shows that the market is extremely euphoric in January 2021. The level can be compared to the 2000 dot-com bubble. Investors keep increasing their risk preference without the fear of a market crash. This indicates a possibility of an upcoming market correction.
“Current euphoric readings signal a 100% probability of losing money in the coming 12 months”.
– by Levkovich, Citigroup chief U.S. equity strategist
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Risks Invovled
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There are market bubbles.
However, don’t try to time the market.
S&P 500 PE ratio
Another chart to look at is the PE ratio of S&P 500 index. The estimated PE ratio of February 2021 is around 40 times. It is slightly under the PE ratio of 2002 when Nasdaq hit a bear-market low. Note that the high PE ratio in 2021 is contributed both by low earnings and high stock price. The company earnings are affected by lockdowns due to the pandemic. On the other hand, the market cap of the top five tech companies accounts for 20% of S&P 500 index weight. The fundamentals of the five companies provide some support to their high stock price. Overall, the market index PE ratio is still within a manageable range.
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Index weight (as of Feb 2021):
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1. Apple 6.7%
2. Microsoft 5.6%
3. Amazon 4.4%
4. Facebook 2%
5. Tesla 1.9%
S&P 500 PE ratio
Human psychology – Certainty
After reading the article “Uncertainty and Panic”, human psychology is another factor we should look at.
People prefer certainty. For example, because of the high uncertainty related to the presidential election last year, the stock market plummeted. After the election result came out, the market went back to its original pace.
To the investors, the certainty they feel now comes from the coming vaccination process, the government financial support, better-than-expected performance results from top tech companies. One highly uncertain event is needed to make the investors feel a strong enough panic to sell.
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Historical factors for bubbles bursting
Meanwhile, negative news that are certainty can also burst the bubbles. Historically, it invloves increasing interest rate. It is because a high interest rate imposes pressure on those overvalued companies with weak fundamentals. With an increasing financial pressure, which weakening the profitability of the companies, the stock price drops.
However, a low interest rate environment will be prolonged as what the article “Talk of a 2000-style stock-market bubble burst is all the rage — but here’s one missing ingredient” mentioned:
“Fed funds futures give zero odds of a Fed interest rate increase through mid-2022.”
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Lastly, after the stock market went through several bubbles and downturn, more rules were introduced to stabilize the financial market. It is possibly that the fiscal policy and monetary policy help the economy expand. Then, the market bubbles are gone when cash flows go into the companies to support high net profits.
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What can I do?
Some people might not think the economic policy the U.S government conducted prevents the stock market from future crashing, so it will be a good opportunity for them. Again, as I mentioned above, most investors are not recommended to time the market. Shorting the market or investing in options would expose the investors to high risk.
A safe way to invest in the opportunity, which is buying inverse strategy index ETFs or mutual funds. The inverse ETFs are like other stocks that sit in your portfolio. It acts as a hedging tool in your portfolio. When the market increases, the gain from the rest of the portfolio absorbs the loss, vice versa.
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**Disclaimer:
All the contents on the website are personal sharing. Please do your own research before buying or selling any stocks.