Are we in a bubble?

By November 23, 2021 Financial Planning
Are we in a bubble

With property and share markets trading close to all-time highs, it’s reasonable and perhaps prudent to consider whether we are in a (asset price) bubble. Bubbles cannot grow indefinitely and at some point, all bubbles burst.

Is the share market about to crash?

Share markets around the world have been incredibly resilient throughout the pandemic and almost all markets are trading above pre-pandemic levels. That probably shouldn’t come as a big surprise, as government fiscal support here and abroad has been unprecedented and interest rates couldn’t be much lower.

Rivian is a good example of a bubble

There are some very clear examples of bubble-like share market valuations. The recent listing of shares in Rivian Automotive Inc. in the US (NASDAQ) is a perfect example. It listed on 9 November raising $US12 billion from investors. Rivan is valued at $US110 billion making it the 5th most valuable automotive manufacturer in the world, behind Volkswagen, which sells 2.8 million units (cars) per year. It’s worth almost as much as Australia’s most valuable company, CBA.

Perhaps the most noteworthy thing about Rivian is that is hasn’t manufactured one product yet. That’s right! It hasn’t generated $1 of revenue, let alone a profit. It is true that Amazon has agreed to buy 100,000 electric delivery trucks from Rivian, which are to be on the road by 2030, but it effectively hasn’t manufactured one unit. There is no conceivable way on earth that a $US110+ billion valuation could be justified for this company. It’s insane.

But not all stocks in the US are overvalued

It is true that the large US tech companies have contributed substantially to the US stock market’s returns over the past 10 years. The FANMAG stocks now account for almost 24% of the S&P500 index. The total value of these six companies is almost $US8.5 trillion. Japan’s entire stock market is worth $US6 trillion. It is also noteworthy that Tesla’s market capitalisation (value) has added almost $US0.5 trillion to the S&P500 index since joining it in December 2020.  

But some of these tech companies have been driven by sound fundamentals. Take Apple as an example. It took 38 years to reach a $US1 trillion market valuation in 2018. But, it only took 2 years to double its valuation to $US2 trillion (by mid-2020). It is currently worth more than $US2.6 trillion. A lot of this growth in value has been driven by underlying earnings (profit). Its trading on a PE ratio of 28 times which is not implausible. In fact, its relatively easy to justify.

It’s happening in Australia too

There are signs of bubbles in different companies in Australia too.

Cloud-based accounting software provider, Xero has a market capitalised value of $22 billion. It reported a loss of $6.5 million for the first half of the 2022 financial year. Whilst Xero likes to talk about the lifetime value of a customer, investors are (or should be) more interested in profitability, of which Xero has none.

But also, there are large Australian companies that are trading at attractive multiples. BHP, for example, is trading at a forward PE ratio of only 12 times, which is very low. That is mainly because its share price has fallen sharply over recent months in line with the price of iron ore.

Australian property price bubble?

According to Core Logic, the home value index has risen by 30% in Sydney over the 12 months to October 2021, 26% for Brisbane and almost 20% for Melbourne.

Whilst recent property price growth has been unsustainably high, it’s more important to consider medium term growth, especially considering negative returns in 2017-2019. Over the 5 years to June 2021, the median house price in Brisbane, Sydney and Melbourne appreciated by between 4.7% p.a. and 6.9% p.a. (according to REIA), which is below the long-term average.

Whilst some commentators have recently predicted that property prices will fall, it is interesting to note that medium term returns (5 year) tend to be a good predictor of price falls. I picked the largest price falls since 1980 in Melbourne, Sydney and Brisbane. Here’s what I found:   

  • Median house prices in Sydney fell by almost 15% between 2017 and 2019. The 5 years prior to this period prices rose 13% p.a.
  • In Melbourne, the median house price fell by 11% over 2011/2012. The 2 years prior to this period house prices rose by 24% p.a.
  • Median house prices in Brisbane fell by almost 8% over 1986/1987. The 5 years prior to this period prices rose 11% p.a.

The conclusion is that price growth must be above average for an extended period of time (more than 2 years) for there to be a risk of a correction. Property prices in Melbourne, Sydney and Brisbane have merely made up for the poor growth rate since 2017 (i.e. mean revision). If prices don’t grow by another 20+% next year, I doubt values will fall.

And of course, there’s bitcoin

It would be remiss of me to not mention crypto in a blog about price bubbles. The total value of Bitcoin is now more than $US1.1 trillion. And the market value of all crypto is circa $US2.6 trillion, which is worth more than Australia’s entire share market! Its worthwhile to remind ourselves that decentralised currencies (crypto) are rarely used for anything other than speculation.

Bubbles and micro-bubbles

Rob Arnott is a US market fundamentalist that I respect greatly. In recent interviews, he has talked about micro-bubbles. Tech company valuations are not universally irrational, like they were in the early 2000’s during the dot com bubble. Instead, certain stocks and assets (e.g. crypto) exhibit bubble-like valuations. This is what Arnott calls a micro-bubble.

What created these micro-bubbles?

It is hard to say what’s caused these micro bubbles, but I suspect it’s the combination of low interest rates and Covid lockdowns/restrictions.

Lower interest rates means that people have more surplus cash than they did pre-Covid, and Covid restrictions mean that people spent less on travel and entertainment. As such, people have been willing to ‘gamble’ some of this money on certain assets with the aim of generating a quick return. According to estimates by JMP Securities, individual investors opened more than 10 million new brokerage accounts in 2020 in the USA.

Aren’t valuation fundamentals important anymore?

What makes someone buy Tesla stock at more than $US1,100 per share? Using a fundamental approach would require you to make ridiculously implausible assumptions to justify this share price e.g. it would have to grow at more than double the rate that Amazon has over the next 5 years. Amazon has been a once-in-a-generation growth story.

What stockholders in these micro-bubble assets are buying is not the fundamentals but the popular narrative/s. Narratives such as Elon Musk is a genius and since all his wealth is tied to Tesla, there’s no better incentive for him to make it work. That the price of Bitcoin will continue to rise. That Xero will achieve scale and generate profit in the future.

When will the micro-bubble burst?

When contemplating the answer to this question, there are two important observations to highlight.

Firstly, bubbles can last long and go higher than any reasonable person could imagine. As the saying goes, “the market can remain irrational far longer than you can remain solvent”. Therefore, don’t bet against a bubble (i.e. short sell the asset).

Secondly, whatever ends a bubble needs to come as a surprise to the market. The market is unsurprised by factors that are already reflected in prices such as higher inflation, higher interest rates, end of Covid lockdowns, central bank tapering and so forth. The catalyst, whatever it is, by definition, is something that is unpredictable today.

That said, sometimes gravity is what ends bubbles – prices/valuations get so high that they become unpalatable to everyone – what goes up, must come down. The early 2000’s tech bubble is a good case in point. To date, no one has been able to identify the one thing or things that caused the dot-com bubble to burst. It was merely gravity.

Make sure you have a strategy

If you are invested in micro-bubble assets, then you better have an exit strategy. That is, a strategy that will inform you when to sell and take your profit, before the bubble bursts.

Alternatively, you should invest in a way (methodologies) that ensures you avoid micro-bubble assets. There are still plenty of excellent investment opportunities in all markets. Don’t assume everything is overvalued.