Investment officeNovember 25 2020

Investment Update: Bubbles

2 mins read

StJohn Gardner

Chief Investment Officer

With some markets hitting new highs (US & Japan), investors might justly be concerned that the market could be in a bubble about to burst given even higher valuations and departure of share price from the underlying fundamentals.

A breakdown of the performance of regional indices suggests the seemingly elevated valuations exist with a few large technology stocks – the likes of Facebook, Apple, Amazon, Netflix, Google (Alphabet) and Microsoft (known as FAANGM) in the US and Alibaba, Tencent, Samsung and Taiwan Semiconductor in Asia. European exchanges, which have few large technology firms, have not fared well as a result.

According to BCA Research, the six FAANGM stocks (constituting almost 25% of the market cap of the S&P 500) have returned over 130% since 2018, compared to a mere 35% gain for the S&P 500. Moreover, while the valuations of these stocks are still below 1999 levels, their high multiples have raised some concerns amongst investors as to the sustainability of current valuations, particularly if one considers the current state of the economy.

Historically, nevertheless, valuations alone have proven an ineffective tool for making asset allocation decisions. Financial bubbles were usually formed during periods of easy monetary policy and rampant financial innovation, and popping shortly after interest rates started rising, often accompanied by a stock supply restriction such as government or exchange interference in the free trading of shares.

So, most of the circumstances that have sustained previous bubbles are currently in place. Firstly the easy monetary policy in response to the COVID crisis, and secondly the financial innovations of ETFs and no-commission platforms such as Robinhood which have allowed new retail investors to gain easier access to markets, many of whom have availed themselves of easy debt to gear up their exposure.

But are the conditions for the popping of that bubble yet in place?  Interest rates are not likely to rise in the short term and look set to remain until inflation picks up to around 3% which economists do not expect the US to reach until 2024. Monetary authorities are likely to keep credit conditions easy to help with post pandemic economic recovery such that it is unlikely the Federal Reserve will raise rates for a couple of years. Supply shocks also look unlikely other than the potential for legislation restricting the ability of companies to buy back their own shares, a practice that has reduced the availability of stock for purchase and consequently supported prices.  Some Democratic senators have called for restrictions on this practice and so this is a real possibility.

In conclusion, with hawkish monetary policy still far away and no supply shock apparent in the near future, the bubble in technology stocks looks set to continue in the short term.