Understanding these stock market bubble signs from billionaire investor Ray Dalio and his hedge fund Bridgewater Associates will help you prepare as stocks kept hitting all time highs in 2021! Is the end of the good times in the stock market coming in 2022?
-Is The Stock Market In A Bubble?
-Interest Rates To Stocks Is Like Gravity
-Ray Dalio’s Bubble Indicators
-Halfway There To The DotCom Bubble Level?
-US Stock Market Bubble Gauges
-When Stocks Decline In The Long Term Debt Cycle
-Is The Fed Deflating The Bubble?
-Elevated Expectations Lead To Underperformance
-Liquidity Withdrawal Will Likely Pop The Bubble
-Dalio’s Classic Bubble Definition
Ray Dalio had said where we are in the stock market now is because of “plenty of liquidity and ridiculously low interest rates.”
Dalio defines a bubble as an unsustainably high price and has 6 criteria by which he measures the extent to which stock markets may be in a bubble. These measures include price conditions, discount rates, new buyers, sentiment, leverage, and forward purchases.
If we average out the bubble indicators from February 2021 for the total market and emerging tech, it was comparable to the overall score of 2007 or the Great Financial Crisis / Great Recession. Now that the S&P 500 is 1000 points up from the last time the bubble indicator chart was updated, it might stand to reason that conditions may be even frothier or bubblicious now going into 2022.
Ray had said we are about halfway there toward the magnitude of the DotCom or 2000s Bubble, but this was many months ago so it would be helpful to know how close he thinks we are at this point in time.
The Shiller PE recently went above 40 for the S&P 500 again, only 4 points away from the all time DotCom Bubble high of 44. The Buffett Indicator per Current Market Valuation is reading 67% at almost the same standard deviations above the long-term trend line as during the Internet Bubble (68%) as of 12/22/21.
We are hovering at the levels of market overvaluation that it seems like the bubble could burst at any moment.
I’m guessing we are at least at the 90th percentile of Dalio’s stock market bubble gauge, his May 2021 chart showed we were at the 80th percentile.
Dalio admits that some stocks are in extreme bubbles, especially emerging tech companies, whereas a lot of stocks are not in bubbles.
He also likes to track a basket of bubble stocks, which have been flying way higher than the S&P 500 but appear to have peaked in February 2021. Could this be coincidental with how Cathie Wood’s ARK Innovation ETF also peaked at the same time and is down significantly now?
Some of what could explain this is if growth and innovative companies do really well when interest rates are really low, but then as the government begins to pull back on all the liquidity, that might not be as much of a fuel to grow operations. Maybe this could be part of why some of the bubble stocks are pulling back.
Dalio said that what’s often indicative of a bubble is a rush of new buyers who are attracted by rising prices in the stock market, which had already reached the 95th percentile in early 2021.
This has been evidenced by new brokerage accounts that were opened throughout 2020 and 2021, and a lot more website traffic to the brokerage sites.
While sentiment now is almost as bullish as it was in the 2000s Bubble, it seems like IPOs and SPACs are just as hot if not hotter than they were in the DotCom Bubble. There have been at least 785 companies that IPO’d in 2021 alone, much more than at the peak of the DotCom era.
With US total debt as a percent of GDP being as high as it’s ever been, Ray Dalio in June 2021 gave an update of his long term debt cycle chart in which he showed the overall debt cycle contrasted with money supply and interest rate charts. I superimposed the Dow Jones index on top of that to try to get an approximation of how stocks performed during similar conditions.
It appears that money supply seemed to be at a climax in 1946, similar to now. And then as interest rates began to rise, the Dow Jones fell from 1946 to 1950 before climbing again. So it is possible that stocks might go down as interest rates start going up in the medium term future.
Bridgewater Associates updated that the unprecedented amount of liquidity has caused their bubble measures to flash red in some pockets of global markets. They believe there is likely bubbles in areas of emerging tech, cryptos, SPACs, NFTs, and collectibles.
They wrote that “all bubbles eventually deflate and pop when they run out of the key fuel inflating them,” pondering “whether the modest Fed tightening could begin deflating these bubbles.”
They reveal how trading and call option volumes have been declining and how some of the bubbliest segments are down by more than 25% from their peaks. It’s possible some of the bubbliest areas are deflating already.
A significant amount of the market is discounted to keep growing at a very high rate (20%+), but that’s only to generate average-ish returns of 8-10%. The last time we had elevated expectations, growth stocks underperformed the rest of the market for the following decade.
Bridgewater noted how equities are especially sensitive to the amount of liquidity that has been pumped into the market from all the government’s money printing, and stocks are less sensitive to actual economic growth.
They believe that withdrawing liquidity from the markets will be what most likely pops the bubbles they are seeing, forcing traders to liquidate leveraged positions in a wide market sell-off. This liquidity withdrawal will likely take the form of bond purchase tapering then interest rate hikes.
And while Ray Dalio says that the current stock market may not be in the highest bubble, and we can’t necessarily say that it’s even in a bubble. He said we have to distinguish which stocks are in a bubble compared to the ones that aren’t.
Ray summarized it best when he said “a lot of liquidity, a lot of debt financed, debt monetization, makes for a classic bubble.” So lets see if 2022 will amount to a final bubble countdown or if the new roaring 20s will keep partying on!
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