Ask European fund managers what keeps them up at night and you might hear: “A bubble on Wall Street.”
That’s according to the January vintage of BofA’s European Fund Manager survey, released on Tuesday.
Overwrought euphoria in US equities ranked third on the list of tail risks, behind only COVID-19 vaccine distribution and a tantrum in the bond market. Inflation was number four and “fiscal policy drag” a distant sixth, behind “other.”
While anecdotal, this underscores the extent to which investors are becoming increasingly concerned about the situation in US equities which, for lack of a better way to say it, generally refuse to stop going up.
Valuations are extreme, although, as documented extensively in this instant classic, it’s difficult to say whether a given asset class is or isn’t a “bubble.”
In fact — and I think this is important — making such pronouncements is impossible.
Market participants, and especially veterans and those who’ve been lucky enough to have called tops previously, have a tendency to pass off subjective judgments as objective facts. Financial journalists do the same thing. Habitually.
Let me just put this as plainly as possible: The only way a reference to “bubbles” can be anything other than a subjective judgement is if the reference is to thin spheres of liquid enclosing air (or another gas). Those are bubbles. In a noun sense. There’s also a verb sense which also refers to an objective reality. You can boil something until it “bubbles,” for example.
Outside of those two instances, “bubble” is wholly subjective. So, when you look at the following simple chart, just know that describing it as a “bubble” is not only subjective, it’s meaningless. “Bubble” doesn’t mean “paying 30X for a dollar of earnings.” Again, “bubble,” as a noun, is a thin sphere of liquid enclosing air (or another gas). Period.
Now, you can call that (the chart) a “bubble” and people will generally understand what you’re trying to convey. In that sense, the subjective, adjective form of “bubble” serves a useful linguistic purpose. (And, yes, the word “bubble” as it applies to air-filled sacks, was just made up at some point, but it’s now universally recognized to describe a specific thing, and that specific thing is not any chart of the S&P 500’s P/E ratio or any other ratio for that matter).
The problem comes when asset managers and financial journalists use the term “bubble” as though it’s a noun that’s applicable to asset prices or, even more absurd, to charts that depict various measures which quantify a given relationship between asset prices and fundamentals.
This may all seem too philosophical to you, but my point is simply this: That chart is no more a “bubble” than it is a “car” or a “tree” or a “kitchen counter.”
Failing to make this distinction leads to all manner of spurious conclusions including, but by no means limited to, the notion that market timing is a good idea. Or that policymakers can be faulted for not “recognizing a bubble” as it inflates. It can also lose you a lot of money over time — just ask a blogger who’s spent the last decade (+) foretelling the apocalypse.
Let me give you an example. A journalist (and this time, it’s one I happen to like), wrote the following over the weekend in a newsletter:
But an actual bubble is unmissable.
It looks like this.
He then used some charts to illustrate the point.
Of course, if it were true that “an actual bubble is unmissable,” then that journalist, as well as everyone blessed with at least one working eyeball and a brokerage account, would be filthy rich by now. Because they’d have all bought every “bubble” on the way up, and shorted them precisely at the peak — “actual bubbles” being “unmissable” and such.
This is why people like Jeremy Grantham and Stan Druckenmiller have to keep adding superlatives the higher risk assets go. Last summer, Grantham saw a “Real McCoy bubble.” Druckenmiller saw “the worst risk-reward for equity in my career.”
Go ahead and laugh. As I’m fond of reminding folks, it’s not a sin to laugh at these “legends.” The market “gods” won’t curse your P/L forever just because you chuckled at Druckenmiller. Sure, they’re “legends” in market circles, but let’s be honest here: What percentage of regular, everyday people around the world, do you reckon know who Stan Druckenmiller is? Or Jeremy Grantham? I guarantee you that percentage is less than 5% (and quite possibly less than 1%).
Here’s the reality: Markets are human constructs. They don’t exist without us. If humans disappear tomorrow, stocks, bonds, and the like, will trade until the electricity goes out on the algos. And then that will be the end of markets.
So, we can’t identify “bubbles” in “markets” because that’s an attempt to apply a noun which describes a totally unrelated thing that exists objectively (i.e., a thin sphere of liquid enclosing air or another gas) to what, ultimately, are make-believe constructs (i.e., stocks, bonds) which don’t exist objectively. It’s a misuse of language.
Not recognizing that is a good way to end up suffering from psychological distress manifested very often in the kind of cognitive dissonance illustrated in the figure (below).
That figure is from the same BofA survey cited here at the outset. It shows that despite fears of a “bubble,” 19% of investors in the poll are taking higher risk than normal.
As the bank noted, that’s “the highest reading ever.”
If risk assets were to careen 50% lower later this week, there would invariably be a parade of folks pointing to this article and laughing.
And it would be funny. Precisely because that would prove, beyond a shadow of a doubt, that those folks didn’t understand it.