The Frothy Calls Bubbling Up

In the 11 months since this bull market’s birth, sentiment has come a long, long way. Deep despair and skepticism dominated most of last year, but now that has given way to optimism—even some pockets of froth. Many pundits see this emerging euphoria and extrapolate it across the entire market, calling it a bubble. But in our view, this is premature. While it wouldn’t surprise us if such a scenario developed in time, we think most recent bubble warnings mistake rational optimism for broad euphoria. In our view, these concerns are an opportunity to review what a true euphoria-inflated bubble is—and why we don’t think investors need to act right now.

Today’s bubble chatter runs the gamut. Some focus on stocks in certain markets (e.g., Asia) as evidence of froth.^[i] Others go further, arguing irrational exuberance has taken hold on Wall Street thanks to monetary “stimulus,” fueling “the mother-of-all asset bubbles” in global equities.^[ii] The evidence of the alleged broad euphoria also runs the gamut. Some analysts cite high valuations and equity fund inflows while others make historical comparisons—e.g., the Tech sector’s share of global stock market capitalization now rivaling its proportion during the late-1990s dot-com bubble.^[iii] Anecdotes of individual investors buying shares of unprofitable companies seemingly echo past bubbly periods, too.

Pundits may use the term bubble loosely, but we think investors must dig into the why behind rising prices. In our view, euphoric sentiment is a key bubble ingredient, as it inflates prices and supply simultaneously. Prices jump exponentially due mostly to hype, greed and the fear of missing out (FOMO). Blinding euphoria convinces investors they can see the future of an asset 15, 20 or even 30 years out—and they lose sight of whether reality can meet expectations. Stock supply also surges during a bubble. Companies issue shares, eager to take advantage of higher prices. Investment banks see investors happily buying new offerings at high prices and respond by bringing more initial public offerings (IPOs) with increasingly dubious quality to satisfy this runaway demand. Eventually they overshoot massively, and when demand dries up as investors gradually realize their earlier expectations were too outlandish, prices tank.

In our view, identifying a bubble is more art than science. There is no magic signal, though some data can provide hints. For example, rising margin debt suggests investors are ratcheting up risk to juice returns—so a spike could signal euphoric sentiment. A big pick-up in IPOs and stock-based mergers may be signs of rising equity supply, and if IPOs are low quality and regularly surging out of the gate, that can be a big tell. But we think qualitative analysis is still key, particularly as it pertains to sentiment, so observing the rhetoric surrounding the broader market is critical. What kind of stories top headlines: gloomy outlooks or spectacular tales hyping lucky picks? Are perma-bears receiving acclaim or are perma-bulls the heroes? If stocks are rallying, do experts warn a pullback is “due” or argue good times will keep rolling with no end in sight? Are analysts noticing rising equity supply and calling for caution—or do they deem it rational because of forecasted strong demand persisting far into the future? 

Broad stock market euphoria last took hold during the dot-com bubble that popped in March 2000. During that time, low-quality IPOs flooded the market as investment bankers pushed any company with a tech-sounding name—even if it had no real business plan or revenues. Investors’ expectations became detached from reality as everyone sought “the next Dell.” Clicks equaled cash in the “new economy,” and many behaved as if good times would never end, ignoring deteriorating economic fundamentals (e.g., an inverted yield curve).

While optimism is widespread and IPO issuance is robust, we don’t think global stocks are in a euphoria-inflated bubble today. Yes, parts of the market look frothy. Expectations towards bitcoin and other cryptocurrencies appear detached from reality. Same goes for electric vehicle startups—the big hunt for the next Tesla is driving enthusiasm and an equity supply increase. One such company recently announced plans to go public via a special purpose acquisition company (SPAC)—despite never having sold a single car. If it goes through, we would probably consider that a low-quality IPO. But the SPAC’s price tanked after the announcement, perhaps suggesting expectations aren’t too stretched. At any rate, that is one very small corner of the stock market. Across the broader market—geographically and sector-wise—supply and demand factors don’t appear out of balance.

On the supply side, global IPO proceeds boomed $324.6 billion in the past 12 months ending January 21, and issuance is expected to remain robust this year.^[iv] However, the amount of IPO proceeds alone doesn’t signal euphoria’s arrival—enthusiasm and quality matter, too. According to our research, first-day average returns for US IPOs remain well below the average returns seen during past euphoric peaks.^[v] Though global IPO quality has worsened over the past year, the percentage of low-quality IPOs was higher at points in the 2009 – 2020 bull market—and significantly higher in the dot-com bubble.^[vi] While it is worth keeping a close eye on supply, we don’t yet have the massive wall of high-priced slop typical of an actual bubble, in our view.

As for demand, investor sentiment seems optimistic, but not overly so. Though some indicators flash euphoria—e.g., rising margin debt—many others remain mixed, signaling runaway enthusiasm hasn’t taken hold yet. Moreover, fundamental economic and political reasons support today’s optimism, in our view, as global stocks are rationally looking ahead to a brighter future—one that includes a global economy returning to normalcy thanks to widespread vaccine distribution and gridlocked politics dampening the likelihood of major legislative change.