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Is the stock market in a bubble? What investors need to know

Frothy markets in the US do not necessarily spell a crisis
March 2, 2021

Starting with the Dutch tulip mania of the 1630s, bubbles have been a perennial feature of financial history. More recent examples are the dotcom craziness of the late 1990s and the house price booms ahead of the financial crisis of 2008. As stock markets prematurely raise their glasses to a happy ending to the pandemic, the question arises: are we in another bubble now? 

If so, it is not for lack of worrying. The year started with a record number of Google searches for “stock market bubble,” as US investors ganged up on social media to fight hedge funds. The wild convulsions in the share price of videogame retailer GameStop aroused, albeit in a novel context, familiar concerns about frothy markets, since small investors are notorious for joining the party just before it ends. 

A stock market bubble occurs when the very increase in equity prices attracts more investors to buy more shares. “The rise is under way and may feed on itself until it constitutes a mania,” noted Charles Kindleberger in Manias, Panics, and Crashes. As the bubble inflates, those prices become increasingly untethered from the underlying valuations based on prospective corporate earnings discounted into today’s money.

Among the main stock exchanges, the US market shows the most sign of this behaviour today. According to a long-run valuation series compiled by Nobel laureate Robert Shiller, US equities are in the same territory reached at the end of the 1920s and the late 1990s. That’s a bad sign, since the stock market subsequently collapsed, most famously in the crash of 1929 but more pertinently in the dotcom implosion of 2000. 

On the other hand, the valuations in Shiller’s series are similar to those reached in 2018, after which no great bursting occurred until Covid struck. It is based on past earnings, whereas investors and fund managers anticipate future profits. One factor supporting the US market is that earnings are recovering more than expected from their pandemic collapse. Meanwhile, other markets are less obviously overvalued—notably Britain’s, which has done badly over the past four years. 

Most importantly, high equity prices are underpinned by bond yields that remain extraordinarily low. When long-term interest rates are low, future corporate earnings are worth more in present values, making shares more attractive. Low bond yields are in turn underpinned by central banks’ commitment to maintain ultra-loose monetary policy. 

What could upset this calculation is if the pandemic turns out to have released the dormant bug of inflation. That’s starting to weigh on the minds of investors. Inflation is already up from recent lows, and will rise further as recovery in the oil price feeds through to consumer prices. 

But what matters is whether this is a temporary resurgence, or a more profound jolt that could end the era of “lowflation.” The lesson from Japan, which has been wrestling against deflationary pressures for two decades, is that it takes a lot to shift the mindsets of consumers and businesses. Though bond yields have come off the floor hit last year, that is to be expected during the recovery. Provided inflation expectations stay stable, stock markets may be less unhinged than many fear.