The Stock Market Bubble and the Regulation Paradox

The broad stock market is down about 9 percent from its late-December peak, and appears to be headed for worse. Last week’s drop of almost 6 percent was the market’s worst since March 2020 as the pandemic was hitting.

The broad market was down as much as 3.7 percent Monday, before making up the losses in midafternoon and ending the day with a slight gain. This volatility comes on the eve of a Federal Reserve meeting where the Federal Open Market Committee will decide whether to go forward with planned interest rate hikes.

Some observers blame the market’s swoon on the Fed’s announced decision to raise rates. That policy shift was only the spark that reversed a long bull-market trend. The overall market bubble is actually made up of several distinct bubbles—each toxic in its own terms, and each one well worth our understanding.

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The paradox is that long-overdue regulation has signaled that the speculative party is over. Financial regulators never should have tolerated the abuses as long as they did. The moves by Biden’s regulators to blow the whistle on speculation is one more case of the adage “No good deed goes unpunished.” As the market continues falling, commentators will score a market crash as one more count against the luckless administration.

The Basic Bubble. Very low interest rates invariably pump up stock values, as investors move out of bonds that yield basically nothing and pour into stocks. The Fed’s decision to raise rates—with markets anticipating four rate hikes in 2022—is a signal to investors to shift out of stocks, which of course depresses the stock market.

But that textbook analysis understates just how overvalued the stock market has been. Take the standard indicator of the ratio of total market valuation to GDP. The total market capitalization of U.S. equities stood at some $53 trillion at the end of 2021. In 2015, it was half that. In 2007, before the market crash of 2008, it was only $19 trillion. At the market’s peak in late December, the ratio of market valuation to GDP was well over 200 percent, a historic high.

The Risks of Hyperconcentration. Stock values have never been as concentrated in a small number of hugely profitable companies as they are today, so the decline in the overall market so far this year understates how far the broad market has to fall. This is another hazard of extreme corporate concentration generally.

Today, the top five companies, all tech giants valued at over a trillion dollars each, account for about 22 percent of the stock market’s value. They have outperformed the broad market, understating the market’s coming nosedive. In 2021, the five top-performing tech stocks accounted for fully 50 percent of the market’s total gain.

The tech platform behemoths—Amazon, Google, Apple, Facebook, and Microsoft—have all thrived on lax antitrust regulation. As Congress and the Biden administration belatedly get serious about cracking down on abuses, supernormal profits will dwindle; and with them inflated stock prices.

The concentration of the platform monopolies is only an extreme case of corporations and the stock market generally. America’s 500 largest companies account for over 80 percent of the broad stock market’s total value.

Crypto Mania. Bitcoin and its imitators were a libertarian fantasy come true. No longer would governments and government-regulated banks have a monopoly on creation of money. The self-regulating universe of cryptocurrencies would create a plethora of avenues for frictionless and costless direct transactions.

Leaving aside such problems as facilitation of money laundering and criminal activity, the problem of ascertaining creditworthiness, and the environmental toll of all those crypto computer farms, the crypto mania was an invitation to all manner of bubbles. Bitcoin quickly ramified into imitators and new forms, such as NFTs, and then derivative vehicles such as exchange-traded funds. The burgeoning of these exotic, poorly understood securities (except of course by their sponsors) resembled nothing so much as the layers of derivatives that crashed the economy in 2008 and their conflicts of interest.

Investors poured money into everything crypto. The market value of a Bitcoin rose from nothing in 2017 to a peak of $64,000 last November, and has now lost half its value in just two months. Derivative vehicles for investing in crypto, such as the $27 billion Grayscale Bitcoin Trust, have lost value in 2022 faster than Bitcoin itself.

If the crypto market were limited to a small number of sophisticated investors, that would be less of a concern. But the total market capitalization of cryptocurrency is about $3 trillion.

James Ledbetter, who writes a very smart crypto newsletter on Substack, points out that “cryptocurrency is ostensibly worth trillions of dollars, and is intimately entwined with several large publicly traded companies, the government of El Salvador, holdings in family offices and investment firms, hundreds of millions of individual owners worldwide, etc. There is an entire crypto ecosystem that, at the moment, is in full-blown recession.”

As it happens, the chair of the Securities and Exchange Commission, Gary Gensler, is one of the best-informed crypto skeptics. He actually taught a course on cryptocurrency at MIT for three years before joining the SEC.

Key people at the Fed also favor regulation. The more that this Wild West sector is regulated, the more the air comes out of the bubble. It is Gensler more than Fed Chair Jay Powell whose expected actions throw cold water on crypto mania.

SPACs and Memes. That stands for “special-purpose acquisition companies.” A SPAC is a shell company that sells shares on public markets and then finds a company to fill the shell. Lately, money has poured into SPACs and abuses have become more flagrant.

The whole concept flies in the face of the SEC’s disclosure regime, which requires publicly traded companies to disclose material information to the public and to prospective investors. The whole point of a SPAC is to keep such information concealed. People who buy a SPAC are buying based on inside tips and rumors.

In December, the SEC’s Gensler made a first cut at proposing much tougher disclosure and liability requirements for SPACs. This came just days after news broke that federal regulators are investigating a SPAC scheme involving the new media company of Donald Trump. Predictably, money has flown out of SPACs as a result.

A similar dynamic has occurred in so-called “meme stocks,” companies like GameStop and AMC, which saw soaring valuations entirely outside their fundamentals. These stocks have been cratering for the past couple of months, another sign of sobriety amid increased regulatory scrutiny.

The Powell Put? In the 1990s and early 2000s, then-Fed Chair Alan Greenspan famously (or infamously) kept interest rates extremely low, in order to bail out financial players who had gotten into difficulty due to excessive speculation. Wall Street became convinced that every time markets got into trouble, Greenspan could be counted on to rescue them with extremely low rates. This cynically came to be known as the Greenspan Put (“put” being a financial term meaning the right to sell a security at a guaranteed price).

The Greenspan Put did not save the economy in 2008. The Fed is required by law to pursue maximum employment and price stability. Nowhere is it required to protect against drops in the stock market, though when correction turns into crash and spills over onto the real economy, the Fed pays attention.

With the rate-setting Federal Open Market Committee meeting for two days starting Wednesday, Powell has been whipsawed between two competing goals—keeping the recovery going and fighting inflation. He has resisted those who blame all of the inflation on the robust recovery, but has agreed to some tightening of rates.

Now he has a third concern—a collapsing stock market. This will add pressure on Powell and his colleagues to moderate anticipated rate hikes.

Here is the deeper regulatory paradox: If we want the whole economy to benefit from the tonic of low interest rates, we need tight regulation against speculative abuses. We are belatedly getting some of that regulation, but in terms of maintaining the recovery the belated regulatory crackdown and the Fed’s interest rate policy may be out of sync. Better not to abandon regulation in the first place.

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