Written by: Alex Da Costa
“You never know you’re in a bubble until it pops.”
As autumn falls into winter, a decided chill is blowing in the air and over stock markets. Top of investors’ minds are concerns over a possible bubble. Bubbles present many vexing challenges for participants. How do we know when we are in a bubble? Unlike the soapy kinds, we can only know for sure we’ve had a market bubble after it’s popped. There is no standard definition, but one way to describe a historical bubble is one where investors buy into stocks which ultimately crash and then take many years to recover (and some individual stocks may never recover at all). Many of us carry the scars of the late 1990s / early 2000s “dot.com” bubble. Back then, if you had been unlucky enough to pile into the Nasdaq Composite Index right at the March 2000 high, it would have taken an interminable 15 years to see that level again, during which time you had to endure a massive 78% drop. But while you were not gifted with luck, maybe you were blessed with patience and today your investment would have multiplied nearly 5 times. You may also have been blessed with wisdom and not had all your public equity capital in the Nasdaq!
Now let’s suppose you don’t like the idea of re-living that experience (who would!); what can you do about it? Should you sell all your equities, sit on the sidelines and hope to get back in at better prices in the future? You could, but history shows that the second feature of bubbles is that trading them is fraught with difficulty. Get out too early or buy back too late and you miss returns. Possibly a lot of returns. That is, unless you are in possession of a mythical market crystal ball, something we have yet to encounter on our journeys … though we have met many who thought they had a crystal ball which regrettably turned out to be defective, leaving them with lower long-term returns than the patient investor.
So bubbles are hard to identify ex-ante and even harder to trade. Now that doesn’t mean investors should do nothing in response to markets which appear stretched, but it does mean investors should be very careful about doing anything that could significantly damage long-term returns. The tried and tested approach to success is the same in all markets, bubbly or not: focus on the long term, diversify, rebalance periodically. Going back to the late 1990s, if you had been periodically trimming your exposure back to target, yes you would have missed some returns as markets continued to rip higher, but the ensuing crash would have been less painful. And you would have been in a better position to put money back into the market as valuations became attractive once more.
Back to today. In our last letter, we noted that while there are some signs we may be in a bubble, there are also reasons to believe we may not be. Some commentators have drawn parallels to previous bubbles including the dot.com period. While there are some similarities, we would highlight that there are also significant differences.
Macro: At a macro level, both fiscal and monetary policy are currently on an easing path, which contrasts with most historical bubbles bursting. For example, leading into the dot.com crash, the US Federal Reserve hiked rates nearly 2% while on the fiscal side, taxes were increasing and the US government was reducing spending. A further macro difference often forgotten is that oil prices rose dramatically leading into both the dot.com bubble and the 2008 Global Financial Crisis, whereas oil prices have been stubbornly grinding lower over the past three years. Oil remains the largest source of US energy supply (~38%) and its impact on economic growth should not be underestimated. Tariffs are certainly unique to the current period and are not growth positive. But as we noted last time, the most extreme outcomes have been dialed back and so far, the US economy seems to be absorbing these with less impact than expected. We should also not lose sight of the political cycle. With US mid-term elections next year, the political incentive to pull out all the stops to juice the economy would seem high. In sum, this set of macro conditions would seem more likely to be supportive of economic growth and market expansion than contraction.
Leverage: Another notable difference between now and previous hot markets is that much of the AI infrastructure spend has come from the cash flows of the largest, most successful companies in the world. Leverage is an essential ingredient for a bubble and debt-funded spending has only recently started to accelerate. We think this acceleration warrants close attention and are wary of some of the off-balance sheet financing deals of recent weeks which bear an eerie resemblance to problem lending of previous eras. But it seems more likely that the debt-fueled AI investment cycle has further to run.
Valuations: We agree that valuations are elevated, particularly in some technology / AI stocks. However, we would highlight that valuations are not nearly as elevated as the truly insane levels seen towards the end of the dot.com era where many companies had miniscule revenues and even lower profits (if any). During that period, even well-established companies traded on extraordinary valuations. Let’s take Microsoft, which is the only company from that era to consistently hold a top position in the S&P 500 for the next 25 years. Back then, Microsoft traded on a peak trailing P/E valuation of 60-80x as compared to about 33x now. At the same time, Cisco Systems was briefly the largest company in the world and touched a P/E of 200x as compared to about 29x now. Examining the top 10 stocks in the S&P 500 today reveals only one stock (Tesla) trading at what looks more like a bubble P/E multiple of ~85x. (Not so) Fun Fact: if an investor had been unfortunate enough to buy Cisco Systems at the peak in March 2000, they would have had to wait until November this year for the stock price to (almost) recover to the same level. This demonstrates the point that valuations do matter and the importance of diversification!
Concentration: We agree that the concentration of major US stock markets indices in a few big companies warrants attention. Indeed, the top 10 names in the S&P 500 account for around 40% of the index as compared to around 20% in late 1999. History reveals that while the current concentration is very much at the high end, there have been many other periods where top 10 concentration reached around 30% and stayed there for some time. Analysis also reveals something of a cycle in markets with concentration generally rising in bull markets and falling in bear markets. This makes intuitive sense but like all things in markets, there are exceptions and we would caution using concentration as a signal to time markets (though we would suggest it as a signal to be increasingly focused on diversification). While it is often dangerous to assume “this time is different”, we observe that many aspects of society are increasingly trending towards “winners take most”. The stock market may be the ultimate manifestation of that trend. It is certainly the case that the internet has fundamentally changed the economic landscape and has given companies unparalleled global reach. Nonetheless, concentration is a concern particularly when considered in the context of a US economy where the top 10% of US households by income account for ~50% of consumer spending, which itself accounts for 70% of US GDP. Thus fully 35% of US GDP is exposed to a spending slowdown by that top 10% who also happens to own ~90% of the US stock market.
Putting this all together, we agree there are legitimate reasons to question whether this market is a bubble, but markets are always climbing a wall of worry and the optimist who thinks about what can go right tends to have the long-term edge over the pessimist. In May this year, we suggested investors who were underweight equities consider rebalancing up to target. Just as rebalancing seemed prudent then, we believe rebalancing is still prudent now. Over the long term it is rarely beneficial to be materially underweight equities and equally, when markets are stretched, being significantly overweight increases risk. As we have noted in previous letters, we doubt that US exceptionalism is dead but we do believe diversifying more globally is a sensible way to improve portfolio resilience.
In our Asset Class Outlook, which is available to Prime Quadrant clients, we share our thoughts on the investment landscape.
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