Yes US stocks are in a big bubble. But when will it burst?

There are plenty of indicators to suggest that US stocks are in a massive bubble right now, says John Stepek. Here, he looks at what might pop it.

Lots of clever people have been pointing out that the US stockmarket is in bubble territory. There are lots of indicators you can point to that confirm these suspicions.

Here's just one – apparently a new Spac (a cash shell that goes public with the intention of bringing privately-listed companies to market) is to list on the Nasdaq with the ticker LMAO.

If that's not a sign that the market is bubbly, I'm not sure what is. The real question is – what makes a bubble pop?

The bubble triangle

In their book, Boom and Bust: A Global History of Financial Bubbles, John D. Turner and William Quinn have a useful framework they call the “Bubble Triangle”. To spark a bubble, you need either a major new technological innovation, or a change in government policy. On top of that, three key factors need to be present.

There's “marketability” – how easy it is to buy and sell assets. Looking at today's environment in the US, it's clear that buying and selling assets has become significantly easier even in the last few years. You have the Robinhood smartphone app offering low-to-no-cost trading, and actively encouraging the treatment of the stockmarket as a slot machine. Fractional ownership of stocks means anyone can speculate with almost any amount of money.

There's the widespread availability of cheap credit. This makes it easy to bet on assets with borrowed money. But it also incentivises it – if interest rates are low, it's hard to earn a low-risk return on your cash. So cheap money also encourages a desperate “reach for yield”. Put simply, if people can't generate a positive return on their cash in the bank, they'll move out further on the risk spectrum than perhaps they would ideally want.

The other key factor is “speculation”. That's where people stop thinking about long-term returns and are just looking to get rich quick. In other words, valuations go out of the window, and all that matters is momentum. Price goes up? Buy before it goes up further. Price goes down? Buy the dip. Exhibit A for this particular bubble has to be Tesla, but bitcoin can't be far behind. It's all about the FOMO (fear of missing out) right now. No one's thinking about the downside.

Clearly all of these factors are present today. As for the spark – while this bubble might superficially look like a tech-stock bubble, I think you could make a good argument that it's been driven more by changes in monetary and fiscal policy.

Post-2008, “austerity” was all the rage. You can debate how austere it really was, but there's no question that since 2016, the intended direction of travel for government spending has turned 180 degrees. Beyond lip service, no developed world government is worrying about closing its deficit and the question now is more just how much extra government spending there will be.

There are lots of tech trends to get excited about, and certainly the tech companies have ended up at the heart of the current bubble, but it feels as though they are almost the destination by default, rather than because of one specific theme.

Keep an eye on supply

Anyway, so I don't think there's much doubt that we're in a bubble. But when does it pop? It goes without saying that the answer is “I've no idea” (sorry). But let's try to think it through a bit.

At its most fundamental level, asset markets are like every other market. Price levels are all about supply and demand. You know that old joke – “Why did the market go down? More sellers than buyers” – well, it's absolutely correct.

The “bubble triangle” outlined above, deals with the demand side. On the credit front, at 0% interest rates, and with central banks still buying large chunks of the bond market (and equities in some countries), there's no sign of that going away.

On the speculation and marketability sides – one risk might be a tightening of regulation. Maybe politicians will get a little freaked out by the gamification of investing, or the idea that lots of small investors are going to get burned as and when crypto currencies blow up (the Financial Conduct Authority here in the UK has already made it much harder for small investors to bet on bitcoin via derivatives, for example).

However, maybe what we really need to look at is the supply side. This is the other feature of a bubble. When founders and private equity owners start to get tempted by the valuations that speculative investors are putting on their companies, that's a warning sign. After all, these are the kinds of owners who should best understand the value of the assets they own. If they want to take the money and run, that's a warning sign.

This is why you see IPOs shoot up in the peak years before a bubble bursts. In effect, it's evidence of a massive wave of insider selling. The smart money is getting out while it can. And this wave of selling – embodied by new companies coming to market (thus increasing the supply of financial assets), or long-term holders flogging their shares – is one of the major factors in popping any bubble.

Sir John Templeton made yet another fortune in the dotcom bust in 2000 by taking advantage of this very phenomenon. He looked at the most overvalued tech IPOs, and shorted them just before the end of their “lock-up” periods – after which the insiders would be able to offload their shares.

Anyway. I don't know if we're “there” yet. And to be clear again – this bubble is specifically centred on the US and US assets (although as the US is so important, any crash there would have knock-on effects globally).

In any case, keep an eye on supply. And I'd suggest that you look at your exposure to the Nasdaq and the US in particular, and consider whether you want to rebalance to something cheaper – UK stocks or emerging markets or both. We'll be discussing this in a lot more detail in MoneyWeek magazine in the coming months. Subscribe now to get your first six issues free.

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