6 Signs We’re In a Market Bubble

In The Big Short, there’s a scene where Michael Burry (Christian Bale) is confronted by two of his biggest clients over Burry’s claim of a housing bubble. The first client, Lawrence, tells Burry that “actually, no one can see a bubble. That’s what makes it a bubble.” Burry responds: “That’s dumb…there’s always markers.”

It’s true. There are always indicators, as history has shown. We are currently in the midst of the longest running bull market in history, going all the way back to March 9, 2009. Last February began a large, COVID-induced selloff that corrected course by summer and actually put the market in the green by the end of the year. It was the first time ever a market dropped by 30% and ended green in the same year.

So are we on the verge of the next “Big One?” Here’s five reasons that say we are.

1. Wrong Side of History

As mentioned, we are currently in the longest running bull market of all time. Prior to the 2009-to-present run, the longest was the 1990s, which ran for 113 months. Our current run is at 143 months. Market commentators called last year’s 30% drop the “end of the bull market” but because it came immediately back and then broke the old high I do not consider it the end of the market run. The correction was hefty, but the long term trend line was not broken.

Looking at the list above, prior to our current run starting in 2009, the average bull market lasted 56.83 months. The current run is nearly three times that. Not only that, but the S&P percent change if you include 2020 and 2021 is up to 437.54% taking out the old record from the Roaring 90s.

Simply put, we’re far overdue for an ending to this bull market.

2. Margin Debt is at a Record High

Margin is the difference between the total value of the investment and the amount you borrow from a broker. Basically, you’re using cash or securities you already own as collateral to make more investments in hopes of making a profit. As with other loans, you have to pay back the money you borrowed plus interest. But margin trading comes with risks. If the amount you borrowed gets too large relative to the value of your securities, you will have to deposit more funds. Otherwise, your broker may sell off some of your assets. And remember, even if you lose your entire investment, you’ll still have to repay what you borrowed, with interest.

Website for Robinhood

Any investment bought via credit always runs the risk of margin calls and, eventually, liquidation.

Barry Ritholtz

Margin debt in 2020 reached a record high. Advisor Perspectives has compiled the amount of outstanding margin debt in the S&P 500. The correlation between the amount of debt and the S&P 500 level is not an accident; after all, buying stocks on credit allows you to buy more than you could just on cash alone. By borrowing money from a bank or brokerage to buy stocks (in hopes they go up), funds and investors drive up the market.

The expansion of credit also correlates with past bubbles (and crashes) in the market: the dot com bubble of the late 90s, the housing crash starting in late 2007, and the sharp drawdown in 2020. However, in Jan 2021, the outstanding margin is higher than it’s ever been, lost to the point of going parabolic. The chart below gives a better illustration as to the growing debt burden (or negative credit) overall in the market:

Margin can only expand so far. A bank or brokerage will only lend so much before either the servicing payments or interest becomes too great. There’s also the possibility that a drop in price will precipitate a margin call and the brokerage has the legal power to start selling securities in your account to repay loans. The risk at that point becomes systemic, with multiple brokerages liquidating accounts to get their money back.

For example: I have $100 and I buy 5 shares of AT&T (T). The shares go up in value. I can then use them as collateral to borrow another $100 from my brokerage to buy more shares of T. It goes up, so I borrow another $100 to buy more, and so on. My parents did this during the housing boom in the 2000s: take out a home equity loan to improve the house. The value of the house went up, so the line of credit in the home equity went up, so more could be borrowed for more improvements…and so on. So in my brokerage account, I have over $300 in T stock, only $100 of which was my own money. If T’s stock price drops, the value of the collateral drops, so I get margin called. Worse, if it drops below the price I bought it with my original $100, I could be wiped out. I owe the brokerage $200 regardless, so if all the shares I bought are sold for $200, I have no money left and no shares.

Total wipeout.

Margin debt relies on the “greater fool” theory that pervades every stock market bubble. Essentially, I’m willing to take on the risk of borrowing money to buy stock because I believe there will always be someone (a “greater fool”) to buy it from me. Eventually, there wont be any buyers because prices will reach a point where no one wants (or can) afford a stock. Now you’re stuck with stock quickly losing value that you bought with credit. And if everybody holding that stock tries to sell at the same time or is forced to sell via margin call…well it turns into a landslide.

According to the Financial Industry Regulatory Authority, outstanding margin debt at the end of 2020 was $778.04 billion.

3. Record New IPOs

Jordan Belfort Takes Steve Madden Public in The Wolf of Wall Street (2013)

An Initial Public Offering, or IPO, is when a private company “goes public” by offering shares of the company on the stock market. It is the late stage of start ups: venture capitalists or investors invest money into a company (or person) with an idea, build the company up until it’s functioning and offering a product or service, then sell it via IPO, recouping their investment plus profit. Imagine investing in Apple or Tesla before it went public, then being able to sell off your shares of the company at big returns.

Large amounts of IPOs are also generally seen as a market top or bubble — just look at the dot com craze of the late 90s. Internet startups were dropping shares all over the NASDAQ, with investors desperate to grab anything with “internet” or “dot com” in the name. It eventually became a racket — companies like pets.com that had no real business model or even revenue were being sold to the public.

And now it’s happening again.

In 2018, the number of IPOs of companies with negative earnings (i.e., don’t make money) reached 81%, which happened to be the same ratio in 2000, when the dot com bubble burst. In 2020, the trend only continued. As InsideHook put it in an article titled “Stock Market Mirrors Dot-Com Bubble as IPOs Mysteriously Skyrocket”: “Why are unprofitable tech companies soaring during a pandemic?

According to the Wall Street Journal article “Record IPO Surge Set to Roll On in 2021”:

Defying expectations, investors piled into initial public offerings at a record rate in 2020, and few expect the euphoria to wear off soon.

Companies raised $167.2 billion through 454 offerings on U.S. exchanges this year through Dec. 24, compared with the previous full-year record of $107.9 billion at the height of the dot-com boom in 1999, according to Dealogic.

The coronavirus pandemic turned the typical rhythm of the IPO market on its head, with $67.3 billion raised in the fourth quarter. That amount is roughly six times the total for the first three months of the year.

A lot of this could be driven by retail investors over the course of last year. Axios calls this “The Robinhood effect.” If you recall in my last post titled “Gamestonk,” retail investors (more on them in a minute) dove headfirst into trading stocks using stimulus checks and Federal unemployment bonuses to buy up companies like Tesla.

Even as I write this, the IPO for dating-app Bumble just opened 77% higher than it’s IPO price on its first day of trading. The app disclosed 2.4 million paying users as of September 2020, but also a net loss of $84.1 million…with a net loss margin of 22.3%. With it’s current stock price, the dating app company is valued at $14 billion.

Make no mistake — this is mania. Retail traders are buying shares in IPOs of companies they recognize: AirBnB, Uber, Lyft, Pinterest, and Slack. These are apps and software they know. And they all want to get in on the ground floor in case the stock is the next Tesla or Apple. Just like people didn’t want to miss out on pets.com being the next…well, whatever. Perhaps even more maniacal is the ubiquity of SPACs or “Special Purpose Acquisition Company.” Without going too far down the rabbit hole, here’s The New York Times’s definition: “

These vehicles have only one purpose: to find a private company and buy it, usually within two years. SPACs are sometimes known as “blank check” companies — as in, investors give them a blank check to go buy a business, sight unseen.

Those checks are getting bigger and bigger, with SPACs raising nearly $26 billion in January, a monthly record in an already red-hot market.

As the Times article also asks, “What could go wrong?

4. Crazy P/E Ratios

In case you don’t know what a P/E ratio is, I threw out the formula from the get go. More bluntly, it’s the measurement of how far from reality a company’s stock is. If a company that has 1,000,000 shares makes $2,000,000 than its earnings per share (EPS) is $2.00. Now the same company’s stock is $200/share. So $20 divided by $2.00 is a P/E of 10. Therefore, the higher the share price (or lower the earnings per share), the higher the P/E. A P/E of 10 means it would take 10 years to earn back your initial investment through company profits. Another way of looking at it is, people are willing to pay $10 for every $1 a company earns.

This little bit of math is important to understand the impact of a runaway P/E. For the most part, P/E is used as a way to compare valuations between companies. A company with a P/E of 20 might be not be seen as overbought as a company with a P/E of 50. Remember, a P/E of 50 means it would take 50 years to earn back your initial investment through company profits.

Now take a popular stock like Tesla (TSLA), that had a huge run last year due to retail investment interest and cheerleading by ARK’s Cathy Wood. It’s current P/E ratio is 1,268.

If you bought Tesla right now, it would take you over twelve hundred years to earn back your initial investment through Tesla’s profits. Other stocks like Shopify (SHOP) and Square (SQ) have current (as of time of this writing) P/E ratios of 900 and 413, respectively. As a point of reference, a P/E in the mid-20s is traditionally considered “high”. These stocks have become detached from any real financials.

Now expand P/E to the entire stock market, where you aggregate all the companies’ P/E to determine the market P/E. The historical average P/E for the S&P 500 is between 13 and 15. The current P/E for the S&P 500 is 39.87.

For long term P/E analysis, a lot of companies will use something called CAPE — Cyclically Adjusted Price Earnings — or “Shiller PE”. This is the price of a stock divided by the average earnings of the last 10 years. It’s a better way of showing trend over time. Here is the the Shiller PE ratio going back several decades (courtesy of longtermtrends.net):

A December 2020 S&P Global article points out that the market P/E CAPE ratio has now just crossed the 1929 pre-crash level:

The cyclically adjusted price-to-earnings, or CAPE, ratio for the S&P 500 hit 33.1 in November, above the 32.6 level it was at in September 1929, the month before the crash that preceded the Great Depression.

“The fact that we’re beyond the September 1929 levels is obviously an important milestone, and will only add to concerns that current US equity valuations have become disconnected from real economic performance,” Jim Reid, a research strategist with Deutsche Bank, wrote in a note.

To be fair, the article also chalks some of the frothiness “was dismissed by some equity analysts due to the uncertainty of the coronavirus and its impact on forward guidance from companies.” But there’s no denying P/E ratios — like Tesla — are certainly overvalued.

5. Rise of the Retail Investor

“Early in 1928, the nature of the boom changed. The mass escape into make-believe, so much a part of the true speculative orgy, started in earnest.”

John Kenneth Galbraith

I covered a good portion of the boom of the retail investors in 2020 in my Gamestonk post two weeks ago. As of July 2020, retail investors made up over 20% of the entire stock market, fueled by stimulus checks and unemployment bonuses. This was up from 10% only a year prior. A retail investor is defined as someone who buys and sells stock for themselves and not for an entity, fund, or organization.

Global X published an article in October 2020 called “The Renewed Rise of the Retail Investor” and highlighted a key component of the retail investor boom: leverage.

A growing trend within the retail community is the use of leverage to enhance returns. A Yahoo Finance/Harris poll found that 43% of respondents have used margin, options or both since the beginning of the pandemic.19 Traditionally, investors use margin to enhance the returns of small-gain strategies. But it seems that many inexperienced traders today want to supercharge already highly volatile portfolios, bringing them closer to the gains they desire.

Clients are regularly denied access to margin and options strategies due to their inexperience. This wasn’t the case with Robinhood, where higher-level options access originally required a high risk tolerance profile and a certain number of options trades entered on the platform.20 This progression-based system encouraged traders to increase their options activity while potentially overlooking the education component necessary for responsible use. The firm has since updated their options offering, increasing eligibility requirements and educational content.21

Investing can seem easy for the uninitiated when the market’s surging. This makes sense when all you’ve seen is a strong bull market, punctuated by quick pullbacks, over the last decade or so. In this environment, mistaking luck for skill is easy…

Long story short, there’s a party going on right now in Robinhood with loose credit and unchecked greed from inexperienced traders. This sounds exactly like the Investopedia definition of “euphoria”, which occurs in a bubble environment before ‘smart money’ begins profit-taking. “Caution is thrown to the wind as asset prices skyrocket.” It also reeks of pre-crash 1929, with retail investors taking out loans to buy stocks. Financial Times recently published an articled titled “Investor Anxiety Mounts Over Prospect of Stock Market ‘Bubble'”, noting that the rise of “inexperienced amateurs as a particular concern.”

As the old Wall Street maxim goes, the trader on the street is the last one in and the last one out.

The combination of inexperience, high leverage, and total risk aversion is what usually leads the herd to drive the bubble to the point of popping, usually when the credit runs out. There’s also another big obstacle coming in the next 60 days…

A lot of these ‘newly minted’ retail traders starting buying stocks during 2020’s pandemic lockdown out of boredom and checks coming in from the government. With the surge in the market last year, a lot of the common-name stocks saw profits. Now those same retail traders are going to owe capital gains taxes on any profits realized — and given so many of them were short-term investments (owned one-year or less) they’re taxed at ordinary income rates. With the tax bill for 2020’s investing gains due, traders may have to sell current stocks to pay the tax bill. Given that so many Robinhood traders last year were new to buying stocks, they may not be fully versed on how capital gains tax works, and could be in for a shock.

But it’s not over yet.

For those who lost their job or were furloughed and received the $600 weekly unemployment bonus from the Federal government, those checks are also taxed. For a lot of these pandemic stock traders, huge tax bills could be coming. Some may be aware, others may not. As of May 2020, 20 million Americans were receiving the extra $600 Federal unemployment bonus — most of them on the hook for income tax on money collected. With an unexpected tax bill, a lot of these novice retail investors may look to start selling stocks (taking further short-term profits that will be taxed for 2021) to cover tax bills. Remember, these retail investors currently make up over 20% of the stock market. If a large portion begin to sell to cover taxes, well…

The fuse is lit.

6. Companies Pressured into Debt

Last week Bloomberg noted that companies were being pushed towards taking out more debt due to demand in Junk bonds. In “Junk Buyers Desperate For Debt Are Pressing Companies to Borrow,” the authors call to attention the huge demand for “junk bonds and leveraged debt” that investors want to buy up. Junk bonds are typically considered risky, which is why they pay higher yields (junk bonds are also known as “high yield” bonds). The fact that junk bonds are in such demand means investors are clamoring for high yield or better returns on their investments. This means money managers need to keep issuing new junk bonds to meet demand. And to issue a junk bond, a company needs to borrow money — a shaky company that is at risk to justify the high yield.

This likely means companies that probably shouldn’t be going further into debt are being pressured to go further into debt so money managers can sell their junk bond.

This seems freakishly similar to the housing boom, when banks were offering NINJA (no income, no job verification application) loans just to get the mortgages so they could sell them off. Mortgages were being sold to buyers who were unlikely to afford them, or buyers who already had one or more mortgages on other properties. Cue that other scene in The Big Short:

“I own five houses. And a condo.”

Eventually, risky companies are going to be saddled up with debt payments, and it only takes one or two of them to be unable to make payments and the junk bond is defaulted on.

Honorable Mention: The Buffet Indicator

What kind of post would this be if I didn’t mention America’s favorite investor? The ‘Buffet Indicator’ is a ratio favored by Warren Buffet; simply defined as the entire value of the stock market divided by the U.S. Gross Domestic Product (GDP). The idea is to see how the stock market measures in relation to the country’s economy: a ratio of 1 would be a stock market in parity with economy, basically comfortably supported by the products and services of the nation. To measure the ratio, Buffet likes to take the Wilshire 5000 Total Market Index and divided by the most recent quarter GDP number. Buffet himself calls this “probably the single best measure of where valuations stand at any given moment.”

The Buffet Indicator just hit a record high of 195% this past week.

If you look at the chart above, you can see just how far the ratio has pulled away. In the dot com crash of 2000 and the housing bubble of 2007-2008 the indicator isn’t even close where where it is now. The recent parabolic spike comes as no surprise either — lockdowns and COVID-19 have impacted the service and travel industries, reducing the GDP. But the market continued to go up.

From a February 12, 2021 Bloomberg article:

“It highlights the remarkable mania we are witnessing in the U.S. equity market,” said Michael O’Rourke, chief market strategist at JonesTrading. “Even if one expected those (Fed) policies to be permanent, which they should not be, it still would not justify paying two times the 25-year average for stocks.”

They don’t Buffet the ‘Oracle of Omaha’ for nothing.

I never intended for Quit Your Job to become an investment blog, but investing is a key component to getting out of your soul-crushing 9-to-5 and becoming financially free. Anyone who read my post on Robert Kiyosaki’s Cashflow Quadrant knows the cruciality of the “I” Investor Quadrant. Being an investor means more than buying Apple (AAPL) stock and holding into infinity. You have to know what’s going on in the market, in companies, in economic trends, or you can find yourself wiped out.

And back to the 9-to-5 in no time.

Disclosure: I am not short the market at this time, nor do I have any positions that would benefits from a market drop. I am not a professional investment advisor, nor do I hold any certifications or degrees in finance or economics. I’m just a guy who reads a lot.

Edit: This article was originally published as “5 Signs We’re In a Market Bubble” on February 13, 2021, but after discovering just how high the Buffet Indicator had gotten I wanted to include it in this post. I revised the post from 5 to 6 and added in the BI.

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