Thread by @wolf_vukovic

There has been ample talk about an upcoming market #crash ever since, well, the previous crash.

People point to, among other things, Shiller’s CAPE ratio, at a 38 multiple (second highest ever).

How do we know if we really are in a #bubble? A thread is due.
Let’s dive in👇🧵

1/ Is there anything we can use to tell whether a market is indeed in a bubble? To borrow a quote from The Big Short:

Lawrence Fields: “Actually, no one can see a bubble... that's what makes it a bubble.”

Michael Burry: “That's dumb, Lawrence. There are always markers.”

2/ Let’s examine those “markers” by revisiting what the top authority on market irrationality and exuberance has to say about it – Nobel winner @RobertJShiller

His book Irrational Exuberance anticipated both the 2000 dot-com bubble burst and the 2006 housing bubble burst.

3/ We start with structural factors. Shiller cites 12 precipitating factors, long-term trends that have made contemporary markets in general more prone to asset price bubbles (US-centric, but most trends are present in Europe as well)

4/ - Rise of an ownership society (private property becoming the main method of savings, thus placing more focus on rising housing prices; plus trends of downsizing and lower job security made people more focused on entrepreneurial and speculative opportunities)

5/ - Cultural and political changes favoring business success (encouraging the mentality to hold stocks, not sell them, in order to reap long-term gains from the market)

- Rise of information technology (encouraging striking valuations of new tech companies)

6/ - Supportive monetary policy and the “Greenspan put” (the concept where the Fed is so good for markets that in itself it represents a put option to protect from negative shocks).

This is now just called the “Fed put”. The logic is the same.

7/ - Boomer generation impact on markets (key demographic that started investing and saving up for retirement, which encourages boom cycles)

- Business media news reporting (daily non-stop coverage of markets which builds into the narrative of looking for stock tips)

8/ - Optimistic forecasts of analysts (they support the sales branches of their firms, and have a disincentive to publish negative reports about their clients – the result is an inflation of good ratings given to all companies)

Much like the rating agency conundrum prior to ’08.

9/ - Expansion of contribution pension plans (the 401(k) accounts in the US) (they encourage people to put more money into stocks, bonds or mutual funds, which significantly impacts stock market activity)

- Growth of mutual funds (as a consequence of the pension plans)

10/ - Long-run decline of #inflation (linked closely with the long-term trend of lower and lower bond yields, which obviously encourages stock investment;
plus low inflation environments are, to investors, strong signals of a good and prosperous economy)

11/ - Expansion of trading volumes: discount brokers, day traders, algo trading (due to low barriers to entry for new investors in terms of lower, almost negligent brokerage fees)

- Rise of gambling opportunities (stock markets treated like a casino with winners and losers)

12/ Shiller wrote about these in 2000. How many of them do we see materializing today?

Some are merely long-term trends - ownership society, cultural changes, mutual funds and 401(k)s - but others are arguably even more amplified today.

13/ Monetary policy has been aggressively accommodative to markets, particularly in light of the previous two stock market slumps (in 2008 and in 2020). The ‘Greenspan put’ is now the ‘Fed put’,…

14/ …bond yields are continuing their historical decline, as was inflation prior to the COVID demand shock, while information technology today is much more advanced than 20 years ago when Shiller predicted its dot-com bust.

15/ The final two factors – the ease of access to investing and the rise of gambling opportunities – are best exemplified by new social media apps and new brokerages (like Robinhood) that gamified investing and significantly increased the volume of trading.

16/ So in general, all of the structural factors are there today, even more amplified compared to 20 or 10 years ago, just before the dot-com and housing bubbles.

Housing even went over its 2006 peak (when it increased 100% compared to a decade earlier).

17/ Then there are many amplification mechanisms that create what Shiller calls “naturally occurring Ponzi schemes” – enriching those who got in early, and when it breaks leaves the bag-holders, who got in at the top, with heavy losses.

18/ Furthermore, there is the “this time is different narrative”.
E.g. high valuations are normal b/c the world has changed, new technology warrants high valuations b/c of future expected benefits, globalization/Internet new era that will make people rich, etc.

19/ These narratives build a feedback loop where investor confidence is increased because of past price increases, who then, out of fear of missing out (FOMO), bid up prices even higher, which encourages even more investors to jump in and benefit from rising prices.

20/ Problem is, such narratives (followed by feedback loops) existed in almost every decade with large stock market booms (1920s, 1950s & 60s, 1980s & 90s).

They are almost identical in their justifications to the ones we hear today, throughout the bull market ever since 2009.

21/ Finally, and most importantly, are the psychological factors:
- price anchors,
- overconfidence,
- survivorship bias,
- hindsight bias,
- herd behavior and narrative epidemics amplified by social media (think meme stocks, or $TSLA ever since 2016).

22/ So can we then say we're in a bubble? Yes. Most definitely.

Just by looking at the Shiller CAPE ratio, or by thinking about all the aforementioned factors this becomes obvious.

Does this mean we can predict when it will burst? Not a chance.

23/ So what can we do? First, design your investing strategy so that if you are in the market, you do not lose out too much from a 5-10% correction (like the one that happened in September '21). Second, follow the #bond market for signals …

24/ … of when the Fed will no longer be so accommodative and by that time hold more cash, in anticipation of buying the (actual) dip when the market enters into a more serious correction.

Don’t fool yourself in predicting when exactly this will happen.

25/ If you really want to do some predictions, stick to our weekly surveys and look out for predictable short-term signals.

No, we won’t predict the bubble burst either, just help you navigate through it 😊

And obviously, subscribe to our newsletter!
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