The Stock Bubble Popped. Is It Safe Now?

Over the past several months, I’ve written voluminously about the ongoing de-rating in the most expensive corners of the market.

The process started in Q1 of 2021, when bonds sold off in what now appears as a dress rehearsal for the historic rout that unfolded during the first four months of 2022. A few days ago, I described the “de-frothing” process in speculative sectors and names as “intermittent, but unmistakable” — a kind of “rolling bear market that gradually subsumed any and all manifestations of mispriced duration.”

That process is inextricably bound up with rising yields and particularly higher real rates, which represent tighter financial conditions. The move higher in 10-year reals crescendoed on Monday.

Some analysts have suggested this dynamic has largely run its course and may abate soon. Wells Fargo’s Chris Harvey, for example, recently wrote that the bottom for some high-profile US growth stocks may come “sometime between now and early summer as the sell-side begins to throw in the towel.”

The question, in essence, is whether “enough is enough,” as it were. I don’t have an answer for that because it’s a subjective assessment. We have history and we have averages, but there’s a sense in which “cheap” is in the eye of the beholder, especially when rates, despite having risen sharply over a very compressed time frame, are still loitering near the lowest levels in recorded history. And you can take that as literally as you like, by the way. As BofA’s Michael Hartnett is fond of reminding investors, rates are still near 5,000-year lows.

Suffice to say if you’re justifying lofty multiples on the basis of rates, there’s still a compelling argument for overpaying.

Humor aside, it’s worth quantifying the extent of the recent de-rating in expensive stocks in order to get a feel for exactly where we are in the process relative to historical averages.

According to Credit Suisse’s Jonathan Golub, the recent collapse in multiples may mean the most expensive stocks actually aren’t all that expensive anymore. “Over the past 20 years, the 100 most expensive stocks in the S&P 500 have traded at a 14.1x multiple point premium to the rest of the market,” he wrote, in a new note.

In January, that premium was almost 26x, as the most expensive shares traded on a 43 multiple. “The market’s YTD correction is largely the result of de-rating of these extremely overvalued names,” Golub went on to say, noting that as of this week, the gap was “just” 16.1x, roughly consistent with the long-term average (figure on the left, below).

The figure on the right (above) illustrates the above-mentioned de-rating. It’s fairly dramatic for the most expensive names.

Whether that constitutes sufficient compression to warrant dip-buying is anyone’s guess considering extreme ambiguity around the trajectory of monetary policy, but it’s useful to have the numbers.

Separately, but relatedly, Ray Dalio delivered an “update” on what he described as “the popping of the bubble stocks.” Ray uses a proprietary indicator called (appropriately) the “USA Bubble Gauge.”

“In January the bubble indicator showed that the US equity market as a whole was at the edge of a bubble [while] emerging tech companies [like] Tesla and Roku were clearly in an extreme bubble,” he wrote, before taking a circuitous route to say that although the mania is over, it’s probably not safe to buy. To wit:

Other bubbly behavior (e.g., SPACs, the IPO boom, the big pickup in options activity) financed by the unprecedented flood of liquidity post-COVID had found its way into asset markets, making things bubbly.

Since then, bubble stocks popped. They declined by about a third over the last year, while the S&P 500 is about flat. With those and other developments in the market — e.g., meaningful decline in frothy retail activity, meaningful deterioration in sentiment, and more — the emerging tech stocks no longer appear to be in a bubble, but neither do they appear to have substantially swung to the opposite extreme, so it’s not necessarily true that now is a good time to buy them.

Bubbles can take a long time to unwind (two years in the case of the 1929 bubble, one year in the case of the late ’90s tech bubble) and typically go to the opposite extreme. So, just because they aren’t at a bubble extremes doesn’t mean they’re safe or that it’s a good time to get long. In fact, US stocks in aggregate still look overvalued by [Bridgewater’s] measures. History shows that once the popping begins, bubbles more often overcorrect to the downside versus settling at more “normal” prices.

Take that for what it’s worth which, based on Bridgewater’s stellar Q1 performance, is more than it’s been worth in a long time.

Late last month, the firm’s Rebecca Patterson told Bloomberg rates likely need to go much higher than the Fed currently projects if Jerome Powell hopes to wrestle inflation back down to target.

“The question to us is if it’s enough to get inflation to where markets are discounting it,” she said. “We think the risk is that it is not.”