- UBS strategists say six of the eight signs of a stock market bubble are already here.
- The hype around generative AI has sent stock prices to record highs, raising concerns about a bubble.
- The current situation resembles 1997 rather than 1999, suggesting a bubble could soon form.
Over the past year, there has been a lot of talk about the stock market being in a bubble, as artificial intelligence-generated hype has driven stock prices to record highs.
In a recent note from UBS, strategist Andrew Garthwaite outlined eight warning signs of a stock market bubble, six of which Garthwaite says are already flashing.
In other words, the stock market is not yet a bubble, but it could soon become one.
“The upside risk is that we get into a bubble, and if we do get into that situation we’ll end up in a situation more similar to 1997 rather than 1999,” Garthwaite said.
This is important because stock market bubbles often lead to painful 80% declines when they burst, but Garthwaite says we’re not there yet.
“The only time we would invest on the bubble theory is if it were 1997 and not 1999,” Garthwaite said.
According to Garthwaite, these are eight warning signs of a stock market bubble.
1. The End of the Structural Bull Market – Flash
U.S.
“Bubbles tend to occur when historical returns on stocks have been very high relative to historical returns on bonds, leading investors to extrapolate those past returns as a predictor of future returns, when in fact the ERPs imply future returns that are well below par,” Garthwaite said.
2. When margins are under pressure – Flash
U.S.
While profits at S&P 500 companies have soared over the past year, there’s another measure of corporate earnings that investors should be watching.
NIPA profits measure the profitability of all companies, including unlisted ones, and if they diverge from those of listed companies, investors should take notice.
“If you look at the TMT period, you see that NIPA profits fell and stock market profits rose. A similar thing happened in Japan in the late 1980s,” Garthwaite said.
3. Significant reduction in width – Flash
U.S.
When a stock market is highly concentrated with just a few companies driving the majority of profits, it’s a sign of narrow breadth.
Record concentration in mega-cap tech stocks is precisely what’s preventing mid-cap stocks from generating big returns.
“You can see this especially when you look at the up-to-down line against the S&P 500 over the TMT period,” Garthwaite said.
4. We need a 25-year gap since the last bubble – Flash
“This has led many investors to believe, ‘this time is different,’ and develop the theory that the stock’s ERP must be structurally lower,” Garthwaite said.
5. There’s been a 25-year gap since the last bubble – Flash
U.S.
“The story revolves around power, or more generally technology. In the 19th century there was a bubble linked to the railways, in the 20th century there was a bubble up until 1929 linked to mass production of the car, the electrification of cities and radio,” Garthwaite said.
6. Retailers stepping in aggressively – Flashed
When retail investors invest aggressively in the stock market, the equity risk premium falls to very low levels and valuations soar.
“There is some evidence of this, including a much higher than normal bullish/bearish ratio among retail investors,” Garthwaite said.
7. Monetary policy is too loose – it’s not noticeable
Previous bubbles have occurred when real interest rates were allowed to fall significantly. That hasn’t happened yet because the Federal Reserve has not yet lowered interest rates.
“Financial conditions currently look unusually tight relative to the output gap,” Garthwaite said.
8. Limited decline period extended – no flash
Previous stock market bubbles have seen limited sell-offs of less than 20% over several years.
The S&P 500 has had a painful bear market in 2022, selling off more than 25% at its lows, so there could be a long way to go before this condition is met.
