COVID and the stock market

If COVID Won’t Pop the Stock Market Bubble, What Will?

  • As usual, when stock market bubbles inflate, there are plenty of rationalizations for not worrying about them.
  • Investors believe the good times will last forever.
  • The first step is to recognize recent performance may have produced a bubble.
  • Then you can bet on the bubble for as long as you’re sure it won’t pop.

hand popping stock market bubble

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We’ve been here before. We are currently in the later stages of witnessing a stock market bubble inflate, and as usual, it appears that it will inflate forever, leading to Fear of Missing Out (FOMO).  Even a pandemic could not burst this most recent bubble, although it tried. In the 1960s it was the Nifty 50; in the 1990’s we had the tech stocks, today we have the FAANGs. In the 1990s it was “Trees can grow to the sky”; today it’s “Don’t fight the Fed.” In 2008, it was a different bubble – housing prices were the bubble. Another parallel: 

The Roaring Twenties set the stage for the Great Depression that began in 1929 and lasted a decade that was marked by a dozen “W” crashes and recoveries. The Roaring 2010s may have set the stage for the next great depression.

There are plenty of reasons for Bulls and Bears but beware of the Pigs. As we recently discussed in this article, the stock market will reconnect with the economy; it always does. The more likely reconnection is a bursting of a stock market bubble that was already highly inflated before the pandemic struck.

 

What Bubble?

According to Wikipedia, a stock market bubble occurs when “ market participants drive stock prices above their value in relation to some system of stock valuation.”  Of course, the “some system of stock valuation” is subject to interpretation and judgment. We discuss two such systems here.

The price/earnings ratio is one system for estimating expensiveness. The historically “fair” price for one dollar of earnings has been about $16 – the average P/E ratio is 16. In the past when P/Es have risen to multiples above the average, stock markets have subsequently crashed. As shown in the following, the US stock market is currently priced 35 times earnings, more than twice the average P/E.     

Looking to the far right of the graph, we see that the growth bubble burst in 2000, then recovered only to be slammed by the housing bubble of 2008, and then the 2010s drove up multiples to 35 coming into the decade of the 2020s. Optimists explain that current multiples are justified by the huge success of the FAANG stocks – Facebook, Apple Amazon, Netflix, and Google. These stocks were thriving in the 2010s and got a big boost recently with the pandemic. They currently comprise 23% of the S&P500’s total market capitalization.

We’re being told that the “valuation system” for these FAANG stocks is the “sky that trees grow to” we had in the 1990s growth bubble. Apple is a prime example, having just reached a market value of $2 trillion. As shown in the following, if Apple were a stock market it would be the 7th largest market in the world on a par with the stock market of Canada.  Do you think this represents a “fair” price? If you do, why?  

Warren Buffet has popularized another valuation system. When the value of the US stock market exceeds GDP, it is expensive. This measure has successfully signaled market crashes in the past and is currently at a 180% all-time high. The average ratio is 80%, so we’re currently more than twice that average.

 

The pandemic couldn’t burst the bubble…..

Even though COVID-19 (Corona Virus December 2019) was first identified in December 2019, it was not recognized as a pandemic until February 2020, at which time the US stock market proceeded to drop more than 30% through mid-March. But then remarkably it recovered even though corporate earnings remain in a major slump.

The US stock market has recovered from COVID even though the economy is suffering.

 

The disconnect with the economy

The US economy is officially in a recession, defined as a decrease in GDP of 10% or more:

And unemployment is at 10%, having improved from an initial peak of 15%. For contrast, unemployment in the Great Depression peaked at 25%.

Bursting bubbles

At first, observers believed that COVID would be the match that lit the market’s overvaluation tinder, but they were wrong, at least so far. But the pandemic is not yet over, and its repercussions will be felt for years after a vaccine is found. It’s not going away. In the meantime, other threats could easily create a market crash, and some have intensified like current trade wars with China. These threats are discussed in this article and are summarized as follows:

 

Summary

The US stock market bubble is inflating. The more it inflates, the bigger the consequent pop. We’ve been here before, prompting recommendations  like “Stay the course” and “Buy the dip.”  This advice can work for investors with long horizons. Stock markets usually recover fairly quickly from crashes, but it took a decade to recover from the Crash of 1929. Importantly, our 78 million baby boomers might not recover from the next stock market crash because they are in the Risk Zone spanning the 5 years before and after retirement when investment losses can dramatically curtail lifestyles in retirement. 

You can ride the bubble but remain vigilant for the pin.