The writer, Morgan Stanley Investment Management’s chief global strategist, is author of ‘The Ten Rules of Successful Nations’
Amid much loose talk of “bubbles” popping all over the financial markets, it’s worth pausing to consider if these upheavals really qualify as bubbles. If so, what does history tell us about how far they might deflate from here? It turns out the answers are quite a few, and quite far.
As bubbles peak, they combine objective signs of excess — prices rising much faster than earnings can justify — with subjective signs of mania, such as frenzied trading and borrowing. To some the entire US stock market looks bubbly given its dizzying run-up, but earnings growth has also been extraordinarily strong through the pandemic. Beneath the surface, however, sectors of the market from green tech to cryptocurrency show tell-tale bubble signs.
My research on the 10 biggest bubbles of the past century, from the US stock market in 1929 to Chinese shares in 2015, shows that prices typically rise 100 per cent in the year before the peak, with much of the gain packed into the climactic last months. That finding is closely in line with bubble studies from academics at Harvard and others.
By those standards, there are at least five current bubblets. They include the cryptocurrency market for bitcoin and ethereum; clean energy stocks, including some of the biggest names in electric vehicles; small cap stocks, including many of the hottest pandemic stories; a basket of tech stocks that lack earnings, which is also chock-a-block with famous brands; and special purpose acquisition companies (Spacs), which allow investors a new way to buy into private firms before they go public.
Each of these bubblets is captured in an index that rose in the last year by around 100 per cent, often much more, to a peak value between $500bn and $2.5tn. Day traders and other newbies rushed in, a common symptom of late stage market manias. Now these bubbles are faltering, as they so often do, in response to increases in long-term interest rates. What’s next?
The historical bubbles in my study did suffer midcourse setbacks on the way up, but typically those corrections were around 25 per cent and never more than 35 per cent. Beyond that point — a 35 per cent drop — the bubbles in my sample became monophasic, or stuck on a one-way downhill path.
For the median case, the bottom was found 70 per cent below the peak, and came just over two years after the peak. Except for the index of small-cap pandemic stocks, the other four bubble candidates have all experienced drops of at least 35 per cent, but also of no more than 50 per cent (in the case of ethereum). In other words, they are not likely to resume inflating any time soon, and they are still far from the typical bottom.
There is one new factor that could upset this historical pattern. Despite the rise in long-term interest rates, there is plenty of liquidity sloshing around the markets, with central banks committed to easy money as never before. The risks though are skewed to the downside.
It is important to remember that a bubble is often a good idea gone too far. In the early 2000s, the conventional wisdom was that the dotcom bubble had fuelled mainly junk companies with business plans barely worth the napkins they were written on. Later, researchers found that, compared with other bubbles, those in the tech sector produce many start-ups that fail but also help launch major innovations. For every few dozen dotcom flame-outs, there was a giant survivor such as Google or Amazon that would go on to make the economy more productive.
By and large, the bubblets of 2021 fit this profile. The tech trends that accelerated during the pandemic, from teleconferencing to online learning, will help increase productivity for long after the pandemic passes. The demand for greener cars and energy is very unlikely to abate until climate change does. Though often ridiculed as “blank cheque companies”, Spacs can also be looked at as an innovative new way to finance initial public offerings.
The most intriguing new idea is cryptocurrency. Impassioned debate over its future helps explain the gyrations of bitcoin, now on the far side of its third massive run-up in eight years. It is an outlier to which historical patterns may not well apply. And there remains a sound case for a secure digital store of value which cuts out the middlemen and offers an alternative to the overstretched US dollar.
Skimming off the froth will be painful for many. But history will judge the bubblets of 2021 by what they leave behind, not just by how far they fall from here.