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Thanks to loose monetary policies and the Fed’s massive money printing, the stock market has frequently been setting new records since the March 2020 correction. This comes during a time when our country is going through the roughest recession in almost a century.
Can the stock market bubble keep inflating or will it burst? Here’s a look at the market today and what we think is on the horizon.
Market euphoria is at an all-time high
Let’s start by looking at the stock market over the past 20 years, which covers the dot.com crash, the Great Recession, and the current pandemic. During each crisis, the stock market dropped significantly and didn’t recover for years. In fact, it took over a decade for the market to recover the losses from 2000. The difference today is that, despite the pandemic’s suckerpunch to our economy, the stock market recovered almost instantaneously and climbed to new highs:
The next chart shows exactly how historic this is. Below is Citibank Research’s Euphoria/Panic Index, which combines a long list of market mood indicators. Typically, the market tops out when the index reaches the Euphoria line—with two exceptions: the tech bubble and today:
It could be argued that, based on precedent, the current Euphoria phase could last another year. However, in terms of sheer magnitude, the past year makes 2000 look like just a small bump in the road. There’s simply no comparison for the level of exuberance we’re seeing today.
Is market speculation a sign the bubble is about to burst?
Legendary investor Jeremy Grantham of Grantham, Mayo, & van Otterloo describes the current market bubble as one of the “four most significant and gripping investment events” of his life. (The three others were the Japanese asset price bubble in 1989, the tech bubble of 2000, and the housing bubble of 2008.)
“The single most dependable feature of the late stages of the great bubbles of history has been really crazy investor behavior, especially on the part of individuals,” Grantham added. “For the first 10 years of this bull market, which is the longest in history, we lacked such wild speculation. But now we have it.”
What drives the speculation? “Accommodative monetary conditions and zero real rates extrapolated indefinitely,” says Grantham. This is the result:
The Fed has committed itself to continue its money-printing and low-interest rates at least for 2021, and a huge stimulus package is on its way, so the party could continue for a while longer. But no party goes on forever, and when this one ends, the hangover is going to be long and painful.
Market valuations are breaking all records
Another indicator of the state of today’s market is the Buffett Indicator. Warren Buffet’s favorite indicator shows when markets are overbought or oversold, and It is—surprise!—also at an all-time high:
This is another clear sign that the current market is unprecedented—it’s madly overvalued. The only time the indicator came close to today’s value was in 2000, and we all know how that ended….
Buffett’s favorite indicator doesn’t stand alone, however. It’s just one on a long list of indicators that all say the same: valuations are at shock-inducing levels:
Let’s bring this point home with another chart. In the wake of the burst of the tech bubble, 45 stocks on the S&P 500 Index were priced at 10 times their sales—investors were paying 10 times revenues! Have investors learned from that? Well, today, almost 60 of the stock on the S&P 500 are trading at over 10 times revenues:
Another critical point concerning the market is the breakdown in the correlations between the stock market and its individual stocks. A healthy index moves together with the majority of the stocks in it. However, at this time, the number of stocks that are outperforming the S&P 500 Index is plummeting, which means that the entire market is carried by a few stocks. That is a recipe for a crash.
Earnings are expected to disappoint
Last year, the S&P was up 18.4%. An equally weighted portfolio of FAAAM (Facebook, Alphabet, Amazon, Apple, Microsoft) and Netflix was up 55%. The contribution of that group to the S&P 500’s growth was 14.35%, while the “S&P 494” gained only 4.05%.
What are the chances the FAAAM+N stocks will repeat their 2020 performance and rise another 55% in 2021, especially given the widespread expectation that earnings will drop like they did the last three quarters?
Lockdowns are continuing, and it’s very uncertain, to say the least, what this year will look like in terms of the pandemic and economic recovery. Millions of Americans are without jobs, and the number will grow as businesses close temporarily or permanently. This means that earnings are probably going to keep disappointing.
“But pent-up demand will keep the market going.”
Some analysts say that once all this is over, pent-up demand will be unleashed on businesses, driving up earnings and, thus, stock prices. We see two objections to this:
First of all, we don’t know “when all this will be over.” We’re still being kept indoors by a pandemic whose grip may be tightening and last much longer than anyone had dared to predict. Yes, vaccines are rolling out, but new strains of the virus are popping up, making it uncertain when we’ll be able to return to “normal.”
Second, it’s a huge assumption that people will a) spend all the money they have saved up and b) spend it on the same things they would have spent it on had there been no pandemic.
Millions of Americans have already piled up tens of thousands in debt because they lost their jobs, while millions of other Americans have had to dive into their savings to make ends meet, including their retirement savings. And of the ones who haven’t lost their jobs and income, many will be more hesitant in their spending in order to build up some savings should the pandemic resurface or another crisis ensues.
The past year has scarred a generation for life, and we will be more financially conservative, The premise of all this pent-up demand is flawed: the transition back to “normal” will be slow in all aspects of our life, including our spending habits.
How large can the bubble grow before it bursts?
There are plenty of warning signs in the stock market today, and the disconnect between the stock market and the economy is deeply troubling: today’s stock market valuations are much higher than in the fall of 2019 when the economy looked fine and unemployment was at a historic low.
Investors are caught in a market frenzy without precedent, but nothing can keep going up forever—eventually, it must come down.
Once the market bubble bursts, it will cause a series of chain reactions that may go beyond our wildest imagination. We saw what happened when the tech bubble and the housing bubble burst; it took years to recover even partially, and many Americans are still suffering the consequences. Those bubbles pale in comparison to today’s market, and the crises that followed them will be no match for the next financial crisis.
How do I achieve financial security when the stock market is flashing red?
As you’re approaching retirement age, the risk profile of your IRA changes; you’ll typically want to exchange high-risk assets for low-risk or safe-haven assets to minimize the uncertainty about your financial future and achieve financial security while meeting your financial goals.
The best road towards financial security is to diversify with an asset that is uncorrelated with stocks so that you’re hedged against the next stock market crash. That asset is gold. It has proven time and again that it protects and even grows investments when other assets collapse. You can find our full guide on gold as an investment for 2021 here.