The runaway performance of tech stocks, and especially the so-called ‘Magnificent Seven’, has led many to question whether a bubble is about to burst. We don’t think so. Even if a bubble is forming, we’re still in the early stages.
Austria, March 2000. I’m skiing with one of my friends. After a few runs he signals to stop as he needs to make an urgent call. I can’t really follow the conversation, but I later understand he’s subscribed to the initial public offering (IPO) of internet service provider World Online.
“I didn’t realise you’re an investor too,” I say. “I wasn’t until now,” he replies, “this is going to be my first investment. I went all in – the IPO seems like a sure thing.” I’m flabbergasted, and ask him what he knows about the company. “Not much,” he replies, “but all these tech IPOs are going bananas on the first day so what’s the risk?”
See also: Why investors need to look beyond the election noise
I still regret that I didn’t recognise this conversation for what it was: one of the clearest sell signals I’ve been handed in my career. World Online had a projected market value of €12bn with revenues of just €64m. I’m still frustrated that I didn’t sell every stock I owned that day.
To the moon
In my 30-year career as an investor, stockmarket bubbles have always been a fascination.
The combination of hope, fantasy, greed and almost unstoppable herd behaviour drives a perfectly reasonable narrative – like the idea that artificial intelligence (AI) will impact large parts of society and increase productivity – into overdrive, with investors extrapolating exponential profit growth into eternity and sending valuations into the stratosphere.
The most expensive tulip bulb ever sold was the Semper Augustus. Historical sources show that a contract for a single bulb sold for 5,200 guilders at the height of Tulip Mania, more than three times the typical yearly earnings of a merchant in Amsterdam at the time.
After the bubble bursts, everyone understands asset prices were bonkers, but in the middle of the mania the attraction can be irresistible and it can even be considered a career risk not to participate. As Citi CEO Chuck Prince once said, “As long as the music is playing, you’ve got to get up and dance.”
Are we in bubble territory?
Over the years I have constructed a ‘bubble indicator’, which helps me judge whether markets are in danger of implosion. The bubble index contains 36 sub-indices in subcategories like excessive valuations, the macro environment, speculative trading and leverage, investor sentiment, and signs of herd behaviour.
The latest reading of the LGIM Bubble Index (which I previously called The Heiligenberg Index in a vain attempt to ensure my name echoes through the ages) shows some frothiness and a very slow increase, but it’s still quite far from bubble-like levels.
Some seeds of exuberance are present. We are late in the economic cycle and there is plenty of liquidity in the system. AI is an archetypical technological breakthrough that is often the catalyst for excessive optimism, feeding the idea that “this time is different”. Pockets of the market have very rich valuations and market concentration in performance is rising.
See also: Scottish Mortgage’s Ben James: Three headwinds turning into tailwinds for our portfolio
However, there remain plenty of signals that we are not yet at nosebleed highs. Overall leverage is not excessive. Financial deregulation and financial engineering facilitating easy money and a rapid increase in leverage aren’t yet omnipresent. M&A and IPO cycles remain relatively normal versus the mania we saw at the end of the 90s.
The fact that the bubble has not yet occurred doesn’t make further increases in prices a given. Bubbles are difficult to anticipate, and full acknowledgement only happens after the burst.
There’s no doubt that US equities are rich relative to their own history, other equity markets and compared with bonds. We derive from this that returns over the medium term are likely to be below average, but this doesn’t tell you much about expected returns over the next three years.
But valuations are not, in our view, excessive like in the late 90s, when investors invented completely new valuation measures like ‘price per click’ instead of price earnings. In fact, some frothy areas such as the SPAC boom have already deflated.
Are we nearly there yet?
The LGIM Bubble Index is at a level comparable with 1997 in the tech bubble or 2005 in the US housing market bubble, suggesting a bursting isn’t imminent.
AI could feed a narrative that grows into an exuberant mania. However, this is just one possible outcome. It’s by no means guaranteed, or even the most likely outcome. As such, other macro questions remain very relevant.
We continue to believe in diversifying our portfolios. Though we like equities with AI exposure, we don’t believe investors should go all in on the theme in anticipation of a bubble emerging.
Special thanks for Roger, a friend for life and a great predictor of stockmarkets, for helping to shape my thinking around market bubbles.
Emiel van den Heiligenberg is head of asset allocation at LGIM
See also: HSBC private bank arm says it’s time for clients to take on more risk
