What is a “bubble” and are we in one?
Those two questions are a perennial obsession for market participants and especially for the financial media. There’s always a bubble somewhere according to someone.
But in 2021, the bubble calls are even more prevalent than usual for a laundry list of reasons, not least of which are readily observable manifestations of what looks like outright delirium, whether it’s Bitcoin at $60,000 or GameStop at $200.
Add to that stretched multiples, industry “legends” upset with themselves for missing out on what ended up being one of the most spectacular rebounds from a bear market in recorded history and extreme consternation in some corners about the possibility that stimulus checks are fueling speculation, and you’re left with a deafening cacophony of warnings.
On Monday, Goldman was out with a 46-page tome called “Bubble Puzzle.” If you’re familiar with the bank’s research, it’s the latest strategy paper by Peter Oppenheimer, who spoiled the drama right up front. “A guide to bubbles and why we are not in one,” read the subheader.
So, there you go. We’re not in a bubble, according to Goldman.
Despite knowing the conclusions, the paper itself is still worth a read — or a skim, depending on how much spare time you have. Oppenheimer noted what I’ve emphasized repeatedly — namely that it isn’t possible to conjure a definitive definition of “bubble” as it relates to markets.
“A reasonable working definition might be a rapid acceleration in prices and valuations that makes an unrealistic claim on future growth and returns,” he wrote, adding that even that admits of caveats. For example, just because one asset class or company is appreciating rapidly doesn’t mean everything else is. And sometimes things re-rate (higher) because the underlying fundamentals actually have improved that much (i.e., enough to warrant bubble-like appreciation).
“Bubbles develop when rapid price rises depend solely on hope and possibility rather than on fundamentals, ultimately overstating the achievable potential,” Oppenheimer went on to write, before offering the following list of famous historical examples:
1630s – The Tulip Mania in Holland; 1720 – The South Sea Bubble in the UK, and the Mississippi Bubble in France; 1790s – The Canal Mania in the UK; 1840s – The Railway Bubble in the UK; 1873 – The Railway Bubble in the US; 1920s – The Stock Market Boom in the US; 1980s – The Land and Stock Bubble in Japan; 1990s – The Technology Bubble, Global; 2007 – The Housing / Banking Bubble in the US (and Europe)
Note that Bitcoin is right up there with the “best” of them, eclipsing even the Tulip Mania.
Despite the inherent impossibility of pinning down exactly what constitutes a bubble, Goldman listed “a few consistent hallmarks,” where “a few” means nine. They are: “Excessive price appreciation & extreme valuations; New valuation approaches justified; Increased market concentration; Frantic speculation and investor flows; Easy credit, low rates & rising leverage; Booming corporate activity; New Era narrative and technology innovations; Late Cycle economic boom; The emergence of accounting scandals and irregularities.”
You might fairly suggest that almost all of those conditions are met today. The only exceptions are the late-cycle bit and the absence of large accounting scandals, although really, those are never “absent,” they’re just not yet known. In fact, I’m not sure I’d put that in a list of bubble characteristics. People lie, cheat and steal habitually. They’re not anymore inclined to do so during financial bubbles than they are at any other time.
In any case, the table (below, from Goldman) shows which boxes are currently checked.
When it comes to excessive price appreciation, Oppenheimer wrote that “the key issue is whether the price rises are ultimately justified by the fundamentals and, therefore, whether the valuation overstates the likely future returns that can be achieved.” That’s intuitive and, in a sense, begs the question. That is: If we knew that, then we wouldn’t define the price rise as “excessive” in the first place.
He ran through a series of examples depicting “pockets of exuberance,” but ultimately came away with a relatively sanguine view of the broader market. “If we look at the S&P 500 – the best-performing of the major equity markets – the rise over the past few years has been impressive, particularly in Technology, but it is not nearly as extreme as the explosive rise that accrued during the late 1990s,” Oppenheimer remarked, adding that,
Unlike many bubble periods, the fundamental EPS for the leading Technology companies and for the more widely-owned favored retail stocks have significantly outstripped those of the rest of the market, so that the rise in the performance has been supported by superior growth and fundamentals. It has been based on achieved reality, not purely on hope and possibility.
As you can imagine, the “it’s all relative” argument received plenty of attention from Goldman. While the bank admitted that a bevy of valuation metrics are very high relative to history across markets, that’s at least partially attributable to all-time low rates.
“One major valuation in equities that does not look stretched [is the] equity risk premium [which] remains high in most cases even relative to the low interest rate and inflation environment post 2000,” Oppenheimer remarked. That’s true pretty much across the board, whether you look at the US, Europe or Asia.
He drove the point home, writing that “in the bubble of the late 1990s, investors were so confident about long-term future growth that they were prepared to buy equities offering a dividend yield of 1% when the prevailing risk free rate was 6.5%.”
To say the situation is different in 2021 would be an understatement. The idea of a 6.5% risk-free rate is totally foreign to investors these days.
“Today in the US the dividend yield and the 10-year bond yield are very similar, and the effective yield is even higher than this when we take into account share buybacks,” Goldman reminded folks.
The bank went on for another 29 pages, but the short summary (above) and short selected quotes are sufficient to communicate the gist of Goldman’s message, which is summarized at the end of the first section.
“Equities, along with most financial assets, do look expensive relative to history and there are pockets of exuberance, but, much of this can be explained by historically low levels of interest rates,” Oppenheimer wrote, adding that although elevated valuations may well mean subdued returns over the long-term, “they do not point to a broad based valuation bubble in equity markets.”