Workers install new Waterford Crystal triangles on the New Year's Eve ball for New Years Eve Celebration in New York City.
Tayfun Coskun/Anadolu Agency/Getty ImagesThe New Year’s Eve Champagne has been imbibed, but concerns about bubbles will persist well into 2021.
There wasn’t much to celebrate in 2020, a miserable year for the economy and humanity in general. At least there was the stock market. Despite the Covid-19 pandemic, which ground the U.S. economy to a halt, the Dow and the rest of the major indexes finished the year at or near record highs. As is so often the case when there is a wide chasm between stock market gains and economic pain, many investors start to wonder if we’ve witnessed a massive financial bubble.
There’s certainly evidence for such a view, if that’s your inclination. Like the cartoon Tasmanian devil—hungry all the time and leaving a path of destruction behind it—investors have chased the newest new thing ever higher. QuantumScape (ticker: QS), virtually unknown just a few months ago, has gained 745% since announcing it would go public via a special purpose acquisition company in September, if the SPAC’s gains are counted. Chinese electric-vehicle maker NIO (NIO) saw its share price increase more than tenfold in 2020. And then there were the hot new offerings Airbnb (ABNB) and DoorDash (DASH), which gained 116% and 40%, respectively, since going public in December, and made investors scream “Bubble!” like the dot-com era all over again.
“We aren’t in that euphoric-moment bubble territory just yet,” says Michael Arone, chief investment strategist for the US SPDR Business at State Street Global Advisors. “But there are certainly red flags to suggest we could be heading there.”
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About those red flags: The sheer number of initial public offerings has helped fuel the comparisons to the dot-com bubble, as nearly 500 companies went public in 2020, the most since 1999. But that number may overstate things a bit. If only operating companies with share prices of $5 or more are included, then just 163 initial offerings hit the market, according to data from Jay Ritter, a professor at University of Florida Warrington College of Business—about a third of the 476 that went public in 1999 and only the most since 2014. And even with some of the hottest IPOs, it’s possible to make a case that they can grow into their valuations, Ritter says. “In 1999 and 2000, it was a bubble with 100% certainty,” he explains. “With a company like Airbnb, an established market leader, the chance that the company disappears in five years is zero.”
SPACs make up the majority of the discrepancy in the IPO numbers in 2020. The blank-check companies accounted for 248 offerings last year, more than four times the previous record. That might be bubbly in and of itself, but if it is, it’s a very 2020 kind of bubble, as investors, unable to lock in reasonable returns in the bond market, bet their cash on empty shells, hoping for the next QuantumScape.
Gambling on the stock market appeared to be a favorite pastime for investors in 2020. Margin debt—the amount of money borrowed against stockholdings to play the market—hit a record $722 billion in November, its first record high in two years. That sounds scary. But margin debt often hits record highs as the stock market rises, making it a notoriously bad timing tool. What’s more, margin debt as a percentage of the overall value of the market is now near a 15-year low, which suggests that investors aren’t overextended just yet.
What has changed is the pace at which investors are adding to their debt. It’s up about 50% from its spring low, and that kind of surge has happened only six times since 1960. A quick spike in margin debt hasn’t always been a problem for the market, particularly in the short term, with the S&P 500 index gaining a median 1.7% in the six months following such a surge. Problems can show up further out, however: The S&P was down 2.3% one year out, and down 7.4% two years after the surge. “Over the past five years, all the ‘sell now!’ statements from those bearish on the market, using margin debt as an excuse, haven’t had much empirical support,” writes Sundial Capital Research founder Jason Goepfert. “[There] is more of an argument now that it’s starting to become a warning sign. A minor one, still, but a warning nonetheless.”
A better way to spot a bubble: look at whether a stock, asset class, or fund has gone “parabolic,” or seen its trend steepen as it moves higher. Bay Crest Partners’ Jonathan Krinsky looks at how far an asset is trading above its 200-day moving average to see just how extended it is and whether a bubble could be in the offing. The price of silver, for instance, peaked at 75% above its 200-day moving average in 2011 before tumbling 44% by the end of the year. The Nasdaq 100 peaked 60% above its 200-day moving average in 2000, while oil was 45% above its 200-day when it peaked in 2008.
Using those numbers as a framework, the S&P 500—which trades about 16% above its 200-day moving average—wouldn’t be in a bubble, nor would the Nasdaq, which trades 23% higher, though they are extended. The market’s hot spots, however, might not be so lucky. Nothing has been hotter than the ARK family of exchange-traded funds. They have massively outpaced the stock market—the worst-performing, ARK Fintech Innovation (ARKF), has merely doubled in 2020, while ARK Genomic Revolution (ARKG) has more than tripled, and the group’s flagship fund, ARK Innovation (ARKK), has gained 170%.
The funds have done it by owning a who’s who of innovative companies, including Tesla (TSLA), Square (SQ), Roku (ROKU), and Invitae (NVTA), and their success has attracted massive inflows. But the stock market gains might be unsustainable. ARK Innovation is now 67% above its 200-day moving average, while ARK Genomic is 82% above it. “The definition of parabolic is a trend that accelerates its steepness as it moves higher, which is what ARKK is doing presently,” Krinsky says. “This can continue in the short term, but we would be cautious on this ETF and many of its holdings as we head into 2021.”
Still, the market has shown itself remarkably resilient to mini-manias. The surges in pot producers like Aphria (APHA) and Canopy Growth (CGC), fake-meat companies like Beyond Meat (BYND), and even bankrupt companies like Hertz Global Holdings (HTZGQ) this past summer failed to ding the overall market when the stocks collapsed. That’s probably because so few of them are actually included in the primary market indexes. That, of course, is changing. Tesla, up 743% in 2020 alone, recently was added to the S&P 500, but even a massive drop in its price couldn’t take down the index on its own. “There will be pockets of volatility,” says Quincy Krosby, chief market strategist at Prudential Financial. “But it won’t spread and lead us into a bear market.”
None of this is to say that the market is in a great place. At 22.5 times forward earnings, the S&P 500 is far from cheap, and the Shiller price/earnings ratio, at 33.9 times, is even higher. Those valuations make sense only relative to zero interest rates in the U.S., as even expensive multiples look attractive when the alternative is earning nothing on cash.
That is, of course, unless the economic recovery that investors have pinned their hopes on really does cause earnings to return to pre-Covid-19 levels faster than the market is counting on. Even those who see signs of mania in the index’s rally acknowledge that won’t happen anytime soon. “It awaits proof that the faith in this big economic recovery later in 2021 was faulty,” writes David Rosenberg of Rosenberg Research. “That is quite a long time away.”
Our bet is that the earnings recovery does materialize, and that markets will hold their own. But we still aren’t expecting much more from the S&P 500. The index gained 16% in 2020 and 29% in 2019, and rarely climbs more than 10% for a third year in a row, according to Nicholas Colas, co-founder of DataTrek Research. The S&P 500 has posted three or more years of double-digit gains just five times since 1928, with the most recent occurring from 2012 through 2014. “If we had to guesstimate, we’d say 80% of all the baseline good news expected in 2021 is already incorporated in an S&P 500 at 3700 in late December 2020,” Colas writes.
A quiet year might be just what the stock market needs to put the bubble fears to rest. Is that too much to ask?
Write to Ben Levisohn at Ben.Levisohn@barrons.com
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