The long bull run that started after the downfall of the financial crisis of 2008 has been the longest in US history, and just like any significant bull run of the past, this one too has turned into a bubble, with speculative fever and animal spirits emerging in its late stages. There are multiple indicators that clearly show the financial market’s incredible overvaluation and disconnection with fundamental economic growth, yet those signals have been completely ignored until now.
This is mostly because of the unprecedented coordination between fiscal and monetary policies, and the Federal Reserve’s unseen approach to money creation and inflation. To get a quick but representative picture of where markets are right now in terms of valuations, we can look at the Schiller P/E ratio (Price to Earnings ratio based on average inflation-adjusted earnings from the previous 10 years), which is currently standing at 39.62x, the highest since the 2000 dotcom bubble and the second-highest in history.
Meanwhile, the so-called “Buffett indicator”, which is the ratio of the total United States stock market valuation to GDP, is at all-time highs at 216%. Those values are currently 73% above the historical average, suggesting that the market is extremely overvalued.
Never before did we have three asset classes in bubble territory at the same time: The real estate market is well above 2008 levels (approximately 50% more expensive); the bond market is the most expensive it has ever been, and stock valuations are sky-high. Of course, this is all perfectly seasoned with hysterically speculative investor behavior that we have seen building up since March 2020 (according to a Schwab survey in April 2021, 15% of current retail investors began playing the market in 2020) and which has caused wild speculation in “meme stocks” and cryptocurrency markets.
While identifying a bubble is a possible task, the practice of estimating when it will pop is practically impossible. However, we can try to identify the elements that represent a systemic risk to the stock market and the economy in general, and which could cause the bubble to finally pop.
S&P 500 Shiller P/E ratio (1880-2021)
United States House Price Index (1992-2021)
Inflation, Tapering & Interest rates
While the Federal Reserve has been completely ignoring inflation in the past months, it is becoming clearer to investors that it’s far from a “transitory” phenomenon driven by supply chain disruptions, but rather driven by monetary policies. In fact, it’s impressive how Jerome Powell has managed to keep a straight face while talking about “transitory” inflation, after doubling the money in active circulation in 9 months during 2020, a dangerous and unexplored monetary experiment. While certainly astonishing, the Fed has a long tradition of being incapable (or unwilling) of addressing asset bubbles, the same way that Bernanke said in 2007 that the housing market was “rock solid” or Greenspan didn’t see any issues in the stock market before 2000. But, back to the current situation, today’s latest CPI numbers of October 2021, show a YoY price increase of 6.2%, the largest since 1990. Yet, this number is still significantly lower than real inflation, as the 1980 methodology-based CPI shows an increase of over 15% and the 1990 based shows an increase of over 10%. Inflation crushes earnings, destroys purchasing power, and hits the economy hard by reducing overall consumption; and while the Fed announced it would start reducing its asset purchases in November, it still didn’t take any significant steps towards hiking interest rates to fight inflation. So, in a period where interest rates are zero, efficient asset allocation is made impossible by an overvalued stock market, bonds are overpriced and real estate is at all-time highs, is there really a better alternative to losing money on cash for the intelligent investor?
China’s real estate bubble
China’s Evergrande, the country’s biggest real estate developer, was about to default a few hours ago. With over 300 billion US$ in debt and over 1000 subsidiaries, the “too big to fail” giant is desperately fighting for survival after trying to pay interest on its bonds during the last months. To really put the size of the company into perspective, we should think about the company’s total assets, which are worth approximately 2 trillion yuan, equivalent to 2% of China’s GDP. In addition to the company having 1.5 million deposits and a wide range of businesses from mineral water to electric vehicles, the problem in China is much broader than the company itself. Real Estate accounts for 29% of China’s GDP and is the engine of the world’s second-largest economy. Selling pressure in the real estate market could collapse prices, making other real estate developers (which base their business models on assumptions of indefinite eternal rising housing prices) default too, as is already happening with Fantasia and Kaisa group. The Fed warned for the first time on Monday about potential “systemic threats” that could have ripple effects all around the global economy. The Chinese government has made it clear that it won’t be bailing out Evergrande to avoid creating moral hazards.
Cryptocurrencies
The cryptocurrency market is now valued at approximately 2.8 trillion US$, over 10 times what it was worth at the beginning of 2020 (US$ 270 billion). While the world sees it as the future, it should be perceived more as a systemic risk to the stability of the financial system. Cryptocurrencies have no intrinsic value other than more investors driving up prices, and comparing them to gold, is a bit like being the Turkey in Nassim Taleb’s Turkey problem, since they only exist since 2009, right at the beginning of the long bull run.
“Consider a turkey that is fed every day, every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”
Gold has passed the 5000-year test, and in comparison, cryptocurrencies surely haven’t survived thanksgiving yet.
Total Crypto Market Capitalization and Volume (in US dollars, 2015-2021)
Anything else that we don’t know
Like it often happens in this kind of scenario, it’s not what you know that hurts you the most but what you don’t know. Taleb (who is particularly fitting in today’s topic) would call it “the impact of the highly improbable”, but with markets currently dancing on a knife’s edge, we could as well call it “the impact of the incredibly possible”.
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