Getting bubbly

Is the U.S. stock market currently in an AI-fueled bubble? That’s the question I asked back in March, and my answer was “No, not even close.” Since then, new data has come in, and my answer has changed. As of July 2024, I still think we’re not in a bubble, but now we are getting close.

Here are my previously discussed Four Horsemen:

First Horseman, Overvaluation: Are current prices at unreasonably high levels according to historical norms and expert opinion?

Second Horseman, Bubble beliefs: Do an unusually large number of market participants say that prices are too high, but likely to rise further?

Third Horseman, Issuance: Over the past year, have we seen an unusually high level of equity issuance by existing firms and new firms (IPOs), and unusually low levels of repurchases?

Fourth Horseman, Inflows: Do we see an unusually large number of new participants entering the market?

What I said before was, “As of March 2024, we may perhaps hear the distant hoofbeats of the First Horseman (overvaluation), who has not traveled far since he last visited us, but there is no sign yet of the other three.”

What’s changed is the Second Horseman, who is now trotting into view. But there’s still no sign of the other two horsemen; for the aggregate U.S. stock market, we see neither issuance nor inflows.

First Horseman, Overvaluation

Let me comment on three aspects of current market valuation:

• Historical norms
• Expert opinion as reflected in public statements.
• Expert opinion as reflected in private conversations.

For historical norms, here’s a table summarizing valuation measures from Robert Shiller:[1]

The table shows three time series. First, Cyclically Adjusted Price Earnings (CAPE), the ratio of today’s market price to trailing real 10-year earnings. Second, the nominal 10-year Treasury rate. And third, “excess CAPE yield,” calculated by Shiller as the difference between CAPE earnings yield and the real 10-year rate. When the excess CAPE yield is negative or low, that means stocks are unattractive relative to bonds.

The table shows that, as has been widely reported, CAPE is very high today and has only been higher around prior bubbles in 2021 and 1999. The market ain’t cheap.

The only point I want to make is that the 2021 bubble was different from 1999/2000 in one key respect: interest rates. In 1999, both nominal and real rates were high and the excess CAPE yield was negative, implying that there was an obvious alternative to investing in overpriced stocks. In 2021, in contrast, both nominal and real rates were very low and the excess CAPE yield was positive, so that one could argue that stocks were fairly priced relative to bonds.

Today looks closer to 1999 than to 2021: a stock market that looks high relative to bond markets. So in that sense, today’s market looks more bubbly than 2021, though less bubbly than 1999.

Now, obviously I have not done a comprehensive valuation exercise or predictive analysis. But in the spirit of wildly jumping to conclusions based on limited data, here is one further observation: looking at the table, July 2024 looks a lot like October 1998. Similarly, the Fed’s April 2024 Financial Stability report shows an estimated equity risk premium that is the lowest in twenty years, but not as low as 1999/2000.[2]

Turning now to expert opinion, I am aware of two public statements by members of my Flagrantly Overvalued Markets Committee. Neither supports the idea that we are currently in a bubble. First, as of July 2024, Aswath Damodaran estimates a forward-looking expected return on stocks over T-bills at 4.1%, still a healthy number and about twice as attractive as his estimates for 1999.[3] Second, Robin Greenwood’s “froth forecast” says the market is not especially frothy right now, because the trailing rise in market prices has not been dramatic enough.[4] So according to my FOMC, the market is not flagrantly overvalued today.

However, in private conversations, I get a different impression. Talking to academic economists in mid-July 2024, I got a 1998ish vibe. When I asked them if they thought the market is overvalued, they almost all said yes, sometimes adding “of course” or “definitely” and mentioning megacap tech stocks. I don’t think the overvaluation sentiment among finance professors is as strong and uniform as it was in 1999, but it is far stronger than it was in 2021.

I’m guessing the gap between public and private utterances mostly reflects the slow pace of academic research. There were many economists studying stock market overvaluation in 1999 because the market had been overvalued for years. In contrast, today we see mostly visceral reactions to high prices as opposed to formal analysis.

It’s worth remembering that more than three years passed between the famous “irrational exuberance” speech made by Greenspan (motivated by the work of Campbell and Shiller) in December 1996 and the peaking of the market in March 2000. It feels closer to 1996 than to 2000 to me, in terms of academic vibes.

Second Horseman, Bubble Beliefs

I previously showed a table with survey data from Yale’s U.S. Stock Market Confidence Indices,[5] and I said that in order for the Second Horseman to be present:

“I need 65% or more respondents agreeing that “Stock prices in the United States, when compared with measures of true fundamental value or sensible investment value, are too high.”

Below, I show an updated table where I have just added a new row for July 2024. We are not quite at my proposed threshold of 65%, but we‘ve reached 61%, mighty close. With 61% of individual investors saying the market is overvalued but 75% saying that the market is going up, it appears that bubble beliefs are emerging.

Now, the numbers are not as high as 2021 and 2000, when more than 70% of the respondents thought the market was overvalued. But we seem to be getting there, with a pretty dramatic move from 47% overvalued to 61% overvalued in just six months.

As additional information, these numbers are trailing 6-month averages, and of course there is substantial random variation in the survey results. And the survey is not an infallible market timing signal: in July 2017, we saw 63% of individual investors saying the market was overvalued, similar to today.

Other evidence suggests bubble beliefs emerging within specific segments of the market. For example, a recent survey found that 84% of retail investors expected the tech sector to outperform in the second half of 2024, but 61% said AI-related stocks were overvalued.[6]

Third Horseman, Issuance

In terms of net issuance by U.S. firms, we see zero evidence of bubbly behavior. No wave of IPOs. No wave of SEOs. No wave of stock-financed acquisitions. The U.S. stock market continues to be a cash machine, distributing cash to shareholders via dividends and repurchases instead of absorbing cash from shareholders via issuance.

Now, you could argue that it takes a while for issuance to respond to overpricing, and we’ll see a wave of crazy/fraudulent AI-related IPOs in the near future. Maybe.

Back in 1999/2000, the market was expensive, and firms responded by issuing equity. Same in 2021. Today, the market might be expensive, but we are not seeing much issuance. So as far as I’m concerned, we’re not in a bubble yet.

Fourth Horseman, Inflows

As with issuance, I see little evidence of new money or new participants entering U.S. equity markets. We certainly don’t see massive inflows into equity funds (including ETFs) as we saw in 1999. We also don’t see an obvious wave of retail stock trading as we saw in 2021.

I am not sure how the next influx of new money will manifest. Leveraged ETFs? Zero-day-to-expiration options? Single-stock futures? Fractional reverse autocallable private equity? Okay, I made that last one up, but I am sure Wall Street will eventually devise novel schemes for separating retail investors from their money. Give it time.

Conclusion

In summary, I see a market that is expensive but not jaw-droppingly expensive, I see expert consensus that might be moving to bubble territory, and I see bubble beliefs emerging among retail investors. On the other hand, I do not yet see smart money (issuers) selling equity to dumb money (retail inflows).

What will happen next? If you think that we are going to re-live the experience of 1999/2000, Groundhog Day style, where are we today? In the time-honored tradition of wildly irresponsible and soon-to-be-regretted market prognostication (as exemplified by “Permanently High Irving” Fisher), I am going to guess that we are currently in 1997, not in 1999. Maybe a full-blown bubble is coming, but it's not here yet.