Are Stocks in a Bubble?
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The stock market’s year-long boom has been accompanied by a familiar question on Wall Street, one that’s as old as the 17th century and as fresh as this spring’s tulips: Have stock prices been in a bubble destined to pop? Now, the bubble conversation has shifted to whether the air is seeping out, with major market indexes pulling back in March and the tech-heavy Nasdaq flirting with the 10% threshold that marks official correction territory.
Investors should not dismiss the chatter about whether an overinflated market has started to deflate. The Dutch tulip bulb mania in the 1600s wiped out fortunes. Euphoria during the Roaring Twenties led to the 1929 crash and Great Depression. The collapse of Japan’s asset bubble in 1991 resulted in decades-long stagnation. And the end of the internet-stock craze 20 years ago wiped out 80% of the Nasdaq’s value.
Although true bubbles tend to end badly, it’s possible that despite bouts of turbulence, especially in speculative pockets of the market, stocks this time around will resume their upward trajectory. We’ll share some strategies for this challenging market below. But it’s worth noting that bubbles can only be identified in hindsight, and we’re not there yet. Moreover, they can go on longer than you’d think. In late 1996, then–Federal Reserve chairman Alan Greenspan warned of “irrational exuberance,” but stocks kept rising until early 2000.
The weight of the evidence. Bubbles form when irrational investors push prices up to unsustainable levels. The gains are driven by speculation, get-rich-quick thinking and adrenaline, rather than by time-honored investing fundamentals, such as profits, sales and valuation. Many experts blame a recent surge in speculation on a mountain of cash chasing returns. They point to the Federal Reserve’s easy-money policies and trillions of dollars that Congress has injected into the economy during the pandemic.
Whatever the reason, signs abound of excess, or what analysts call YOLO (you only live once) trading. Examples include video-game retailer GameStop’s social media–fueled boom (up 2,442% in intraday trading from the end of 2020 to January 28) and bust (down 92% by mid February); bitcoin’s 100% early-year gain; a surging market for initial public offerings; and Tesla’s brief run above $900 a share, which pushed the electric car maker’s market value to more than $800 billion—10 times greater than General Motors, the biggest U.S. automaker.
This mania reminds some veterans of investors’ infatuation with dot-com stocks in the 2000 bubble. “The crazy stuff we’re seeing today is no different,” says James Stack, editor of the InvesTech Research newsletter. It signals that risks are rising and that investors should tread carefully, he adds. Jeremy Grantham, cofounder of money management firm GMO, says this bull run will go down as “one of the great bubbles of financial history.”
A surefire way for the bubble to pop would be for the economy to overheat, causing inflation and bond yields to spike and forcing the Fed, which has said it will keep rates near zero through 2023, to raise rates sooner. The dive in early March that knocked some highfliers down 15%, 25% and more played out as Treasuries shot up to a one-year high of 1.6%—higher than the 1.5% yield of the S&P 500 index. Higher rates make stocks less attractive compared with bonds and exert downward pressure on growth stocks, whose profits in the future are seen as less valuable today when higher current interest rates get factored in.
But the bulls say the popping of a handful of mini bubbles will mostly cause localized pain in only the frothiest parts of the market—think stocks favored by day traders, such as GameStop, or cult stocks, such as Tesla. Also at risk are hot renewable-energy companies benefiting from momentum-trading strategies and high-growth stocks with high price-earnings multiples. “There are stocks and sectors that are bubbly right now, but I’m not sure that means the entire market is necessarily a house of cards,” says Ben Carlson, director of institutional asset management at Ritholtz Wealth Management. For now, still-low interest rates and a “stronger-than-expected vaccine-led economic restart” remain bullish market drivers, says Jean Boivin, head of BlackRock Investment Institute.
