Insurrections are not usually seen by investors as buy signals. Yet even as rioters stormed the seat of US legislative government last week, stock market indices hit new highs in New York, adding another chapter to 12 months of apparent defiance of economic gravity.
Wall Street, measured by the benchmark S&P 500, was not alone in starting 2021 with a bang. London’s FTSE 100 jumped by more than 6% in the first week of the year as investors took in a heady cocktail of a President Joe Biden ready and able to spend money, cheap borrowing costs, and the hopes that vaccines will end the coronavirus lockdowns. Yet amid the exuberance a serious concern looms: are we on the cusp of another colossal crash?
Some veteran investors believe so. Jeremy Grantham, the British co-founder of the US investment firm GMO, gave some of his fellow investors pause last week when he described “a fully fledged epic bubble” that has grown out of the recovery from the financial crisis of 2008-09.
“Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behaviour, I believe this event will be recorded as one of the great bubbles of financial history,” he wrote in a letter to investors. Analysts at Bank of America joined him last Friday, warning of “frothy prices, greedy positioning” and telling their clients to sell equities.
There is a growing divide in the investment world: on the one side are believers that the recovery from the pandemic will add extra impetus to stock markets; on the other are those who think that bubbles are inflating to bursting point.
There are relatively few investors who do not admit to the existence of speculative bubbles in some parts of the financial markets. The mania for bitcoin, the cryptocurrency, appeared to have dissipated in December 2017, when prices fell from just short of $20,000 to dip below $4,000 in 2019. But enthusiasm for bitcoin is back: after passing the $20,000 mark in December, its price has doubled and hit highs near $42,000 last Friday.
Other contenders for bubble status are Tesla and fellow electric car pioneer rivals such as Nikola and China’s Nio, whose shares have surged in value as investors scramble to stake claims in the green-transition gold rush. The spectacular tenfold increase in Tesla’s market value since the start of 2020 made chief executive Elon Musk the world’s richest person last week. The carmaker is worth more than the next seven most valuable legacy carmakers combined, despite making a fraction of their profits.
Yet bitcoin and Tesla have by no means been the only beneficiaries. While 2020 for most of us will be remembered as the year we were confined to our homes, for financial markets it was a year in which prices escaped their constraints. Paul Tudor Jones, a billionaire hedge fund manager, last month pointed out that more companies were priced at more than 100 times their earnings than at any other point in history – and about 50% more than during the dotcom bubble of the early 2000s.
Guy Monson, chief investment officer at Sarasin & Partners, a London-based investment firm, said 2020 was marked by “near universal asset-price inflation”, a direct consequence of central banks injecting trillions of dollars into the economy by buying government bonds through a process known as quantitative easing (QE).
The virus effectively caused a “no-fault downturn”, said Monson, meaning there was little political pushback against bailouts from government and central banks. Unlike overextended bankers in the banking crisis of 2008-09, it was difficult to blame pub owners or hairdressers for a government order to shut up shop. Central bank asset purchases under QE ran at roughly three times the rate of the financial crisis at the height of the pandemic, Monson added.
The main question keeping investors awake at night is whether Federal Reserve chair Jerome Powell and counterparts such as the European Central Bank’s Christine Lagarde or the Bank of England’s Andrew Bailey will ever be able to raise interest rates to anything like their pre-2008 levels. Even a hint that the Fed might try to reduce the flow of stimulus has been enough to depress markets in the past, notably during the “taper tantrum” of 2013. The jump in borrowing costs was enough to persuade central bankers that taking away support would cause painful stock market drops.
Some argue that, by certain yardsticks, market valuations are not quite as over-inflated. The S&P 500 is worth about 22 times predicted earnings for 2021, higher than the long-term average of about 16, but lower than the 30 hit before the dotcom bubble burst, according to Kiran Ganesh, a multi-asset strategist at UBS Global Wealth Management.
“This is an environment to be pro-risk,” he said, pointing to cyclical companies that struggled during the early stages of the pandemic, such as big industrial manufacturers, banks and utilities companies. However, he warned against “Fomo” – the bubble-stoking fear of missing out – drawing people towards companies that had already seen their values rocket.
Ganesh added that there was little sign central banks had the desire or the ability to raise interest rates and bond yields, which move inversely to prices, above historically low levels, providing the conditions for continued stock market gains. There were particular opportunities for UK companies to catch up with the US, he added, in part because of a Brexit deal that reduced uncertainty, albeit at the cost of raising other trade barriers.
But others believe central bankers’ efforts to stave off financial collapse have stored up problems for the future, and already low interest rates mean they will have little room for manoeuvre if inflation rises or – perhaps more likely – growth does not meet investors’ great expectations.
Central banks were “already vastly overextended” before the pandemic, said Sven Henrich, founder of market analysts NorthmanTrader. Central bankers knew their policies were feeding a stock market bubble with the side effect of fuelling inequality between already wealthy shareholders and those who could not take part in the equity boom, he argued. However, their inability to retreat without causing panic would cause problems if they lost control, he said.
“The concern I have is they have created a massive asset bubble and price distortion,” Henrich said. “They have created this monster that they need to keep feeding.”