The eerie quiet before a financial storm has often been punctuated by telltale signs, and the impending turmoil on Wall Street is no different. In the shadow of the dot-com bust and the Great Recession, seasoned market participants were able to pinpoint patterns that preceded these crashes. Today, UBS has identified eight warning signs of a stock market bubble, and alarmingly, six have already flashed bright red.
These stark warnings come as generative AI hype drives stock prices to precarious heights, reminiscent of 1997’s exuberance. Many Americans are left questioning whether history is on the cusp of repeating itself. In his latest note, UBS strategist Andrew Garthwaite warns of an impending market bubble, triggered by investors’ euphoria-driven allocation to AI stocks.
“The upside risk is that we end up in a bubble. If we are in such a situation, then we believe it is similar to 1997, not 1999,” Garthwaite explains. His insights suggest that although we’re not fully engulfed in a bubble yet, we may be frighteningly close. Amid the growing concerns, one thing is clear: the market appears to be on borrowed time.
Large Loss of Breadth in the Market
Garthwaite points to a significant loss of breadth in the current market as one of the key signs of an impending bubble. Breadth refers to the number of stocks participating in a market rally, and typically, a healthy market will have a large number of stocks making new highs. Imagine the market as a ship with multiple sails. Ideally, all sails would work together to propel the ship forward. However, today, only a few sails are catching the wind, while the rest hang limp. This uneven distribution puts the ship—and investors—at risk of capsizing when the wind changes direction. As Garthwaite notes, the percentage of stocks in the S&P 500 making new highs since February has plummeted, with its performance driven by a few mega-cap tech stocks.
Garthwaite isn’t alone in his concerns about breadth. Other analysts have also noted the worrying divergence between market indices like the S&P 500 and the Russell 2000, which represents small-cap stocks. “The lack of breadth tells you something about the underlying business fundamentals in the economy,” said Sevens Report Research’s Tom Essaye. If the market were genuinely healthy and robust, we would expect a much broader participation across various sectors, not just a handful of giants pulling the weight. “If everything were as healthy as the S&P 500 would have you believe, breadth would be better,” added Essaye.
Experts say that the concentration in mega-cap tech stocks, like Apple’s and Microsoft’s, has created a mirage of market prosperity, masking underlying weaknesses in other sectors. The disparity suggests that the economy may not be as strong as the headlines make it out to be. It’s like having a shiny exterior on a building with crumbling foundations—the illusion of strength can only hold for so long before reality sets in.
Market Mania and Retail Investors
The recent surge of retail investors into the stock market has been another warning sign of a potential bubble, according to Garthwaite. With speculative trading becoming popular, especially among younger investors using no-commission brokerage platforms, the market has seen a surge in activity and valuations of AI startup companies that lack profits. Coinciding with this, the bull/bear ratio—an indicator of market sentiment—has been trending heavily towards bullishness, reflecting the increased optimism among retail investors. Reminiscent of the 1999 dot-com bubble, retail investors are pushing up prices, creating a dangerous disconnect between market valuations and economic realities. While Garthwaite doesn’t believe that we’ve reached the level of a market bubble yet, others, like famed investor Jeremey Grantham, are less optimistic.
“The only bull markets that continued up from levels like this were the last 18 months in Japan until 1989, and the U.S. tech bubble of 1998 and 1999, and we know how those ended,” Grantham warned in a letter to clients. Citing reckless speculation and a lack of fundamental support for current market conditions, Grantham aptly points out that “if you double the price of an asset, you halve its future return.” Put another way, the higher the market goes, the lower its expected returns become.
Needs a 25-year Gap from the Last Bubble
The concept of requiring a 25-year gap from the prior market bubble is not a new one but one that is often overlooked in the midst of market euphoria. This gap allows for a reset and realignment of market valuations to more accurately reflect economic conditions. Popularized by Nobel Prize-winning economist Robert Shiller in his book Irrational Exuberance, this concept suggests that market bubbles are caused by a combination of irrational behavior and speculation. Without the necessary cooling-off period, the market can continue to climb higher, fueled by investor optimism and potentially dangerous levels of leverage.
According to Garthwaite, this time frame also allows a new generation of investors to emerge, often leading them to adopt the mindset that “it is different this time around.” This sentiment can foster the development of theories suggesting that equities should be valued at a structurally lower equity risk premium (ERP). Such beliefs can inflate market valuations, as these investors are prone to overlook historical patterns and the potential consequences of speculative bubbles. The resulting disconnect between historical benchmarks and optimism can create a precarious situation in the marketplace, where caution is warranted.
Has a 25-Year Gap from the Last Bubble
Garthwaite asserts that nearly 25 years have passed since the last major bubble burst in 2000—and the eerie similarities are hard to ignore. Historically, bubbles have been driven by dominant narratives or technological advancements. In the 19th century, railways fueled market excitement and speculation. The 20th century saw a frenzy over the mass production of cars, city electrification, and the radio, culminating in the catastrophic 1929 bubble.
According to Garthwaite, we’re witnessing a similar narrative today. Big tech companies continue to dominate the market, driving unprecedented levels of excitement and speculation. Garthwaite explains, “This narrative either revolves around dominance or more typically technology. In the 19th century, there was a bubble associated with railways, and in the 20th century, a bubble in the run-up to 1929 was linked to the mass production of cars, electrification of cities, and the radio.”
Just as railways and cars once held the market’s imagination, today’s tech giants are causing a high concentration in the market—a pattern that seems alarmingly familiar. The last significant bubble burst in 2000, nearly 25 years ago, with the dotcom crash. The question now looms large over investors’ heads—Is history about to repeat itself?
Corporate Profits Under Pressure
Then there’s the issue of corporate profits. While the S&P 500 profits have enjoyed a steady climb this past year, the overall corporate profitability tells a different story. NIPA profits, which measure the total profits of all private and publicly traded enterprises, have remained relatively flat. Garthwaite notes that this divergence is reminiscent of previous bubbles. “We can see this if we look at the TMT period when the NIPA profits fell while stock market profits rose. The same was true in Japan in the late 1980s,” Garthwaite said.
This pattern suggests that the current corporate profits might be overstated, driven by short-term incentives and accounting tricks. Companies, eager to boost their stock prices and meet quarterly expectations, may be painting a rosier picture than reality. This misalignment between public and private profit figures is often a precursor to a bubble burst, as seen in previous market crashes. And as the saying goes, “what goes up must come down,” and so do inflated profits.
The Final Phase of a Structural Bull Market
The unsettling signs of an impending end to the current structural bull market can also be seen in the behavior of seasoned investors. Veteran market participants are becoming more cautious and skeptical about the sustainability of current valuations. Historical equity returns have far outpaced bond returns, creating a dangerous illusion of perpetual growth. Investors now face unrealistic future return expectations, a phenomenon that often precedes a market collapse.
“Bubbles tend to occur when historical equity returns have been very high relative to bond returns and thus investors extrapolate historical returns to be predictors of future returns,” Garthwaite warns. He adds that future returns, as indicated by the ERP, are significantly below their norms. This disparity between expected and actual future returns is setting the stage for potential financial disaster, as investors chase unrealistic returns and ignore the warning signs.
Market Signals Not Flashing…Yet
The two warning signs that haven’t been triggered yet paint a more nuanced picture. First, monetary policy remains tight. Historically, significant cuts to real interest rates have accompanied previous bubbles, but this hasn’t happened yet. The Federal Reserve continues to maintain elevated rates, even as the economy shows signs of faltering. Corporate bankruptcies are on the rise, and GDP growth forecasts keep getting slashed, yet the Fed remains stubbornly hawkish. “Current monetary conditions look abnormally tight,” Garthwaite notes. If the Fed begins to ease monetary policy, as many experts predict it will, this could be a catalyst for a bubble to form. Until this happens, monetary policy remains a neutral signal in terms of the market’s vulnerability to a correction.
Second, we haven’t experienced an extended period of limited declines. Previous stock market bubbles have been characterized by long stretches of limited downside volatility, where investors continue to pile on risk and ignore warning signs. The recent bear market, which saw the S&P 500 drop over 25%, suggests that we’re not there yet, although some experts argue that the quick recovery and new market highs indicate otherwise. While the lack of such a period may indicate that we’re not at the peak, Garthwaite warns that it doesn’t mean that a correction isn’t coming soon. Both these factors add layers of uncertainty to the current market climate, with a growing chorus of experts warning of an impending bubble burst.
Diversification: A Key Defense in a Bubble-Driven Market
With the parallels between today’s AI-driven market returns and the dot-com bubble of the early 2000s, experts are urging investors to take steps towards diversification in their portfolios. During the dot-com era, investors who diversified their portfolios fared far better than those who put all their eggs in the tech basket. While the tech-heavy Nasdaq index plummeted over 77% during the bubble burst, time-tested assets like gold saw double-digit gains. Experts argue that gold’s unique position as a counter-cyclical asset makes it an ideal hedge against market volatility and bubble-driven crashes.
The lessons from the dot-com bubble are as relevant as ever in today’s frothy market. With investors becoming overly enamored by skyrocketing AI valuations and tech stocks, diversification across non-correlated asset classes, including precious metals, can help mitigate risk in the event of a market correction. Experts say Gold, which has historically shown a negative correlation to stocks, can act as a stable anchor in an otherwise turbulent market. As Harry Markowitz, the father of modern portfolio theory, famously said, “Diversification is the only free lunch in investing.” His words may ring true now more than ever.
If your looking for ways to diversify and hedge your savings against these potential bubbles and more, we can help.
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