Ttwo years ago, almost everyone agreed that one of the great bubbles was bursting. An era of rock-bottom interest rates was coming to an end, shaking virtually every asset class to its foundations. Stock prices plummeted, government bonds were put under pressure and the crypto markets were in free fall. Wall Street’s prophets of doom crowed with joy. The consensus of the past decade – that inflation was dead and cheap money was here to stay – looked as ridiculous as the groupthink of any financial mania. So the pendulum was about to swing: from exuberance to skepticism, from risk-taking to cash hoarding, and from greed to fear. It would take a long time to reverse.
Or not. The bottom for US stock markets came in October 2022. Less than eighteen months later, stock markets around the world are back at all-time highs (see Chart 1). America in particular is on a dazzling course, with the S&P 500 index of large companies that has risen in 16 of the past 19 weeks. The value of Nvidia, a maker of hardware essential for artificial intelligence (AI), has increased by more than $1 trillion in just a few months. Bitcoin hit another all-time high on March 11. This is disorienting for those who blamed the previous frenzy on near-zero interest rates, but this comes after a brutal campaign by central bankers to return them to more normal levels (see Chart 2). Once again, every conversation about the markets flawlessly returns to the same question. Is this a bubble?
Many are thinking not of the most recent bull market, but of the late 1990s, when the dot-com bubble burst. Then, as now, new technology promised to send productivity and profits to the moon, with the innovation in question being the Internet rather than artificial intelligence. The 1990s bulls were right that advances in telecommunications would transform the world and spawn a new generation of corporate giants. Yet many ended up losing their shirt even by betting on companies that would go on to become phenomenally successful. The canonical example is Cisco, which, like Nvidia, made hardware crucial to the new technology era. Although net income in the most recent fiscal year was $12.8 billion, up from $4.4 billion in 2000 (both in today’s currency), those who bought stocks at their peak in March 2000 and continue to hold them today have suffered a real loss of almost 66%.
Cisco therefore illustrates the defining characteristic of bubbles. They rise when investors buy assets at prices completely disconnected from economic fundamentals such as supply and demand or future cash flows. The question of what the asset “value” is goes out the window; all that matters is whether it can be sold for more later. That in turn depends on how many people the speculative frenzy can attract and how long it can last – in other words, on how angry the crowd gets. Once the buyers run out, the craze disappears and there is nothing to keep prices up. Predicting the magnitude of the subsequent fall is as much of a fool’s game as trying to time the summit.
The good news is that this kind of mania is still a long way off. Researchers from the bank Goldman Sachs have analyzed the valuations of the ten largest stocks in America. S&P 500 index, around which a large part of the AI hype has taken place. With prices that are on average 25 times higher than expected profits for the coming year, they are on the expensive side. But they are cheaper than last year, and a bargain compared to the height of the dot-com bubble, when prices were 43 times earnings.
There are other signs that, despite rising stock prices, there is no euphoria. Bank of America’s latest monthly survey of fund managers shows they are more optimistic than they have been in the past two years, but not exactly the case over the longer term. Their average cash holdings are low, but not extreme, meaning they haven’t entered the market with everything they have (nor are they hoarding cash in anticipation of a plunge, as was the case in the late 1990s). Among retail investors, the group that typically maintains the final and most dangerous phase of a bubble, there has been no repeat of the rush to tech funds and meme stocks that occurred in 2021.
Manic episodes
So what would it look like if things took a euphoric turn? A strong signal would be that the gains so far concentrated around a few mega-cap stocks would spread more broadly across the market. The winning streak of recent months has not been dominated by America’s “magnificent seven” tech giants, but by just four of them. Amazon, Meta, Microsoft and Nvidia have left the remaining 496 stocks in the portfolio S&P 500 in the dust. These others, in turn, have recovered from the 2022 crisis much better than the smaller companies represented in the Russell 2000 index (see Chart 3). If investors really throw their caution to the wind, expect them to gamble on riskier corporate roaches, as well as giants – especially those who manage to manipulate the letters.AI” in their annual reports.
One consequence of this is that the pipeline of IPOs (IPOs) should finally start flowing. Things picked up in both 1999 and 2021, with soaring stock prices and exuberant investors proving irresistible to company bosses looking for capital. A confusing feature of the current bull market is that it occurred during a period of IPO drought. E.Y, a consulting firm, estimates that companies going public in America will have raised just $23 billion in 2023, down from $156 billion in 2021. It could be that company bosses are simply more concerned about the economic headwinds than investors . In a euphoric market, such sobriety becomes impossible to maintain.
Similar dangers haunt professional money managers, whose job is to beat the market regardless of whether they think it is moving rationally. If bags look dangerously overvalued, it would be wise to avoid them. But in a bubble, avoiding overvalued stocks—which are the ones that tend to rise the most—begins to look suspiciously like ordinary mediocrity. As the dot-com frenzy reached its peak, Julian Robertson, one of the most respected hedge fund managers of the 20th century, staunchly refused to buy technology stocks. His investors eventually revolted and withdrew their money, forcing his fund to close just as the crash was about to occur. In another sign that a bubble is about to burst, some gloomier voices are being heard from the market.
Investors don’t seem enthusiastic enough yet for all this to happen. But as in 2021, cheaper debt could help get them in the mood. Lenders are shifting money to risky high-yield (or ‘junk’) corporate borrowers, narrowing the spread they pay over government bond yields (see Chart 4). When Federal Reserve officials meet on March 20, any indication that rate cuts are imminent could be exactly the kind of high investors are looking for. Make sure you have some paracetamol on hand for the comedown. ■