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Episode 34

Now it’s a bubble

Published on: June 24, 2020 • Duration: 21 minutes

This week we look at how the nature of the equity market has changed between the highs of February and the highs that are being made in the Nasdaq today. One of the key elements of a bubble that was missing earlier in the year is no longer missing today. In the Chatter we look at how a V-shaped recovery in the survey data is not the same as a V-shaped recovery in the real economy. In the Whisper we look at how trends in Refinitiv data can reveal shifts in investment trends. 

  • [00:00:00] Back in January, when the S&P 500 was making new all time highs, it was not displaying all the signs that we would have expected if the equity market had been a true bubble. But wind onto today, and with the Nasdaq having made new all time highs, there are now far more classic bubble signs than there were earlier this year. That's The Big Conversation. 

    [00:00:24] On January the 22nd of this year, I recorded an episode of The Big Conversation called 'When's a bubble, not a bubble?'. Given that since then, we've had a near vertical decline of 35 percent in the S&P 500, we could say that the equity market was in a bubble back then. However my summary at that time, when the S&P 500 and the DAX were making new highs, was that we currently have prices that are clearly extended, but it would be very hard to say that the public's emotional involvement with asset prices is so extreme that it could lead to the sort of populist mass exit, the results in extended losses in the equity space. My point was, if that was a bubble, it would need to sell off and then stay down, which it didn't. If something is a true bubble, when it bursts, it stays deflated for an extended period of time. A bubble is not just a bubble of valuation, but also a bubble of emotion. A bubble peaks with a mania. There is no mania in equity prices in January. That was a dispassionate and despised rally with the key drivers of equity prices being corporate share buybacks and 401K pension flows. Individual investors were largely absent. There was very little emotional capital invested in the market at the time, apart from the active managers who were continually being trounced by the performance of dispassionate, passive funds. Today, the U.S. equity market, such as the Nasdaq 100 has rebounded back to, or through the all time highs. That is not the normal activity of a market that  was a bubble situation before covid struck. However, this time, the rebound has not only extended the valuation disconnect, but has also pulled in the individual retail investor community who are now attached in a way that has not been seen since the dot com mania of 2000. But firstly, let's look at past bubbles and their price action. What is clear is that they all have an element of extreme public interaction and this emotional attachment creates the mania. We saw this in the dot com boom of 1998 to 2000. When the Nasdaq eventually broke, it took 15 years to regain the all time highs. The S&P, on the other hand, was retesting those highs after about seven years. In China, the government manufactured an equity bubble in 2014 to 2015. Futures volumes exploded with individual investors driving the demand for equity exposure. Eventually, when the bubble burst and the equity market declined, the government was unable to reflate the market despite reducing rates further and then ramping up the liquidity injections at the beginning of 2016. 

    [00:02:56] The Japanese equity market was part of an asset bubble in the late 1980s that also saw insane prices for real estate, particularly within Tokyo. That bubble popped in the last few days of 1989. The equity market has never got close to those levels again. Japanese banks have been in a downward spiral, the end game is still playing out 30 years later, where interest on new loans is now insufficient to cover their cost base. If we move on to the U.S. equity market in January and February of this year, it was a market that was primarily driven by technical players. Buybacks for 2020 pre-covid were already looking like they would break another record of around one trillion dollars set in 2019. Systematic funds (such as risk parity) were still pumping the market with 401K pension flows. The shadow banking system was still leveraging up the Fed liquidity. One of the reasons the Fed started expanding its balance sheet again in September was because some of the key providers of liquidity were struggling for funding. Key commercial banks were hoarding cash rather than loaning funds. Remember how the S&P was in lockstep with the Fed's balance sheet through the end of last year in the early part of this year. The drivers of the equity market pre-covid were therefore rules based or model driven funds working off algos and leveraging the Fed's balance sheet. It's thought that at some point during 2019, the total size of passive funds in the US overtook the size of active funds. These are funds that don't take part in Merrill Lynch or Investor Intelligence surveys. In fact, the three month moving average of mutual fund flows had remained in negative territory for most of the previous few years. Individual investors were not directly engaged. Most engagement was due to the automatic pension fund flows attached to employee schemes. Then covid hit. We saw a dramatic deleveraging that led to a liquidity crisis that also swept up other assets, with the U.S. Treasury market also seizing up by mid-March as the systematic funds and the shadow banking system tried to delever their positions. The sell off was the fastest bear market from an all time high ever. But the rebound has also broken many records. The Nasdaq 100 has made a new all time high. The S&P 500 bounced back well beyond the usual rebounds that were experienced after all the other major bear markets, and a normal rebound would have been to the fifty or sixty two percent retracement level. We saw this with Japan in the 1990s, which rebounded to 50 percent. We saw this with the S&P in 2001. We saw this with the S&P in 1929 when it rebounded between 50 and 62 percent. And we saw this with the S&P in 2018. The S&P today has now retraced back to around about 80 percent of the decline from the all time highs. Even the Russell 2000 has rebounded back beyond the sixty two percent level. So what have been the key drivers? Share buybacks have been postponed for companies that have taken loans through the Corona crisis, and buybacks are expected to be down around about 50 percent on the previous year, although the cash rich tech companies that had been seeing an acceleration and concentration of their businesses did announce around sixty five billion of buybacks for Q2. These are also the companies that had been driving the Nasdaq 100 to new all time highs. The 401K pension flows have also dropped back in the early part of lockdown. They had continued because severance pay kept the flows going for a couple of weeks after lockdown. Furthermore jobs with employee pension schemes in place were less severely impacted than many of the jobs in the leisure industry that bore the brunt of the initial slowdown. However as the lockdown continued and the depth of the slowdown reached record levels, even the 401K pension flows were impaired. And this is all about the marginal flows. It doesn't need to be a dramatic decline, just a slowdown. And the shadow banks, these include the hedge funds who have been providing much of the liquidity over the last decade after many investment banks and brokers were forced by regulation to pare back or even vacate altogether the market making space, after the initial deleveraging shock, they were quickly restored back into the market by the Federal Reserve and other central banks, kickstarting QE on a scale that dwarf their efforts during the crash of 2008. The Fed also announced support for the corporate bond market, which has further helped stabilize risk assets. In fact, so far they've continued to provide actual or verbal support every time that we've seen a wobble since March with the latest coming a few days after the five percent decline in the S&P a couple of weeks ago. But the key difference between February and today is the reemergence of the retail investor who is not only investing their own capital, but also their emotions into the equity market. We can see this in the equity volumes of certain stocks that had been favored by retail investors such as the Jets ETF and Chesapeake Energy, which has been teetering on the edge of bankruptcy. Volumes in many of these names were virtually non-existent before March. And despite some of the less than flattering press, the retail investors have so far done a good job in picking winners. The stocks of choice have not just been headline making names like Hertz, but also stocks that could be expected to rebound in this environment. They have embraced the narrative of dip buying and don't fight the Fed to great effect so far. The Fed appears, however, to be creating an equity bubble within a recession. Rising equity prices, like rising house prices, are non-productive unless individuals can lock in the returns. A few always do, but the majority usually experience capital destruction. It's a lot easier getting into assets, then getting out again. But with the influx of individual investors and traders, we now have the right attributes to be able to say that the equity market is getting into bubble territory. Evaluations were full in February, they are fuller today. Fund inflows have also picked up. Small trader call buying at a 10 to one ratio was recently double the all time high recorded in February, which was already double the highs of the previous 20 years. Individual investors were actually moving into the market pre-covid. When the equity market was at record highs in February, it lacked the mania, it wasn't a bubble. But equity markets at record highs today have the beginnings of mania. It can now be labeled a bubble. Jeremy Grantham of Grantham, Mayo, Van Otterloo and Co. had predicted the equity declines in 2000 and 2008, said in a recent interview: "My confidence is rising quite rapidly that this is in fact becoming the fourth real McCoy bubble of my investment career. The great bubbles can go on a long time and inflict a lot of pain, but at least I think we know now that we're in one." Grantham didn't consider the equity market to have the attributes of a bubble in February. And second guessing how far a bubble could rise is actually a fool's errand. Bitcoin went to twenty thousand when many thought that it had gone too far at two thousand. Today, the Fed looks like it is too scared to let asset prices fall. But just how infinite is their balance sheet is anyone's guess. The equity market has been ebbing and flowing with the rate of change of their balance sheet, and they still appear to be primed at the pump. We don't know how determined the Fed is to backstop prices. We don't know the tenacity of this new breed of retail investor. If many have cut their teeth trading Bitcoin, they probably have a better stomach for volatility than many older investors. Many tried to predict the top of the Nasdaq throughout 1999 and into early 2000 and nearly everyone was wrong. There were great opportunities as well as risks, and the risks can be extreme as this chart of Japanese stock Hikari Tsushin from 2000 shows. It traded limited down day after day. We're not at those levels of excess yet, however. But today, I think we can call the U.S. equity market a bubble in the making. We probably haven't yet reached a peak in euphoria and emotion. We are seeing the battles on social media play out between the believers and the unbelievers of the rally. That in itself is one of the surest historical signs that the final ingredient for a true bubble is in place. And this is one that we are seeing take place in the depths of a recession. But the real issue is that if the bubble deflates, it takes a lot of the stimulus with it. Stimulus that many are expecting will create inflation further down the road. Instead, we could actually see the velocity of money fall even further if it's squandered on nonproductive assets before it gets the chance to hit the real economy. 

    [00:11:10] As the macro data for May and June starts rolling in, more, more people are talking about a V shaped economic recovery to match the V shaped bounce in U.S. equities. Now, before we look at that data, it's worth reiterating that most equity markets have not recovered as much as the US. As of the 19th of June, many markets in Europe were still down between 15 and 20 percent year to date. Also, if we look at China, we can see that the survey data has had a V shaped rebound, such as the nonmanufacturing PMI. And I always caveat that the Chinese data is not always to be trusted, but we can still see some trends developing. Business activity expectations and new orders have rebounded back to pre Covido levels. Remember, these are sentiment indicators such as questions like do you expect next month to be better than last month? They are not an indicator of volume, but we can see that the survey for domestic activity has bounced better than the survey for export orders, i.e. business with the international community. This has recovered, but remains well of pre-Covid levels. Furthermore, when we look at activity in the actual economy, such as real estate sales and real estate investment, neither of these have recovered to former levels. Sentiment that can be shaped by government support have performed well. Whereas the economy outside of China and the areas that still rely on animal spirits are still subdued. As we can see from car registrations China was, not surprisingly, the first to rebound. If the patterns in China data are to be believed, then we are probably going to see similar patterns appear in other parts of the world. Strong rebounds where there can be direct stimulus, but much more tentative when it requires global supply chains and animal spirits to drive them. What makes this event so hard to analyze is how unusual it has been both from the catalyst and the response. Perhaps this chart of U.S. employment during and after recessions gives the clearest indication of this being such an outlier of an event. All the recessions historically followed a similar decline and then a return in employment, with the post 2007 event admittedly standing out in terms of how long it took to recover. But 2020 stands in stark contrast to all these events. This is why we've seen the Citi Bank economic data surprise index lurch from lows to highs. At first analysts were underestimating the depth of the decline and the data was getting much worse by the time analysts had adjusted for the severity of the downturn. They started to overestimate the negative impact and the data started to beat these pessimistic forecasts. It doesn't necessarily mean that the data is good in absolute terms, just that it is not as bad as forecast. When we look at U.S. retail sales, it looks like a very strong rebound, when we look at the month on month figure. But when we look at the value, we can see that the rebound is still well short of the pre-Covid levels, and sales by sector are also a very mixed bag. Sales at garden centers have surged, not surprising for a nation that in part was in lockdown. Sports and hobby goods have also rebounded very quickly again. Not really much of a surprise. Whilst the rebound in restaurant and bar receipts is still very poor and remains only at 2010 levels. Perhaps the key to watch is whether the rebound in auto sales and auto parts was a one off. In May, one in five dollars spent was in this sector, the largest share for nearly three years. Big items may have been given a boost by the surge in bank lending, which has clearly taken advantage of central bank liquidity. But all these rebounds are taking place during the period in which furlough schemes have supported the economy. As furlough schemes are adjusted or roll off altogether, will businesses still need the same number of workers? As discussed in the previous section the U.S. equity market has had a V shaped rebound, but the driving forces have changed. The V shaped rebound in the economy is largely focused on sectors where the stimulus has taken hold. But the stimulus is not permanent. The V shape recovery has not yet materialized in the real economy, in the international economy and in the economy where the stimulus has not been able to hit home. If the stimulus is temporary and if soon to be rolled off, have balance sheets been sufficiently repaired to do the heavy lifting once governments step back? 

    [00:15:34] In this section, we're going to look at some of the trends in data usage that are starting to build momentum but may still be below the radar of many investors. When we look through the use of data, we can usually see some obvious trends. When the S&P 500 recently had its five percent single day decline, demand for S&P 500, NASDAQ 100 and Dow Jones Industrials data shot up, as did searches for news about the oil market when crude oil prices had a significant drop at the same time. I caught up with Refinitiv CEO David Craig, to ask if there are any specific trends that are emerging. For instance, which areas are starting to see an increase in momentum and can we glean any insights from this data on data? 

    [00:16:14] David, first, could you maybe outline what 'data on data' actually is and, and how we can use it? 

    [00:16:22] We're obviously distributing billions of data points around the world every single day. And one of the really interesting site insights that we're getting at the moment is looking on anonomised and aggregated basis well what are our clients retrieving? What datasets are they actually looking at? And what are some of those trends that we can spot literally on an hourly basis of how clients are changing the patterns of the data that they're examining? 

    [00:16:47] And are there any standout trends that are currently building momentum but perhaps have gone unnoticed for now? 

    [00:16:54] There are some really interesting trends that we're picking up, and some of them are things that you would expect and some of them like some of these things, actually you wouldn't necessarily expect. I mean, obviously, people are reading a lot around the news of the Corona virus and disease and pandemics, they're looking at those equity sectors that would be potentially impacted, the highest be they hotels or leisure or airlines, but also the sectors that might not have as much impact. I think one of the really interesting insights that we're gathering, which is in some sense surprising, is the amount of people that are increasing their retrievals on sustainable finance data and ESG data, which is up about 90 percent in some sectors. I think a couple of dynamics are happening here. I think it's been well reported, including by us, that many of the companies and the funds that had the higher ESG scores have performed better through the crisis than the ones with lower scores, even if you take into account the fall in oil price. But I think a second thing that is happening is investors go back into the market and asset managers are rebalancing portfolios, and they're looking very closely at the ESG scores particularly around carbon and carbon equivalent emissions and trying to make sure they rebalance away from those sectors that have created challenges in the past. You're seeing both  an acknowledgment of high performance and high resilience by the investors, but also a desire to move away from some of those more legacy assets that have cuased challenges with higher carbon emissions. The sell side is recognizing that they're catching up with the buy side now, and they're looking at the data to try and create products and capabilities that can support the buy side's investment desire on sustainable finance areas and ESG scores. I think also other sectors are just a little bit slower I think to pick up on this trend. And there's talk in the media, for example, about sustainability being on the backburner through the crisis recovery, whereas in fact a lot of the government actions and things that we're seeing are actually putting a sustainable recovery more at the forefront of the investment and the type of fiscal actions that have been taken for the recovery. So I think you're seeing different sectors of the market basically pick up on this at a different pace. 

    [00:19:12] So that does seem slightly surprising that this has been missed, considering that it's the investment community itself, so the wealth managers, portfolio managers and brokers who have been leading the charge. Why do you think that is? 

    [00:19:25] Well the the highest consumption and the highest uplift was in the investor community in the wealth area, the brokers and the investment managers. The lower actually was in media which is quite curious because often the media is sort of ahead of the trend. It looks like maybe the media is behind of seeing this trend, and what is happening. If data is the new energy, as I like to think about it, just understanding consumption and the patterns of consumption is another source of insight. Understanding how that energy has been used, that data has been used, where it's been used, what types of data people are looking at, is bringing some real insight to the market about where the money is flowing or where the risk is or where the activity and the appetite to investors. 

    [00:20:07] The data is showing a significant increase in demand for ESG data from certain parts of the investment community. Whilst the media have gone cold on this trend, probably because there are so many other investment themes that need covering at the moment. And it doesn't really matter whether you agree or disagree with the theme, in investing is always worth following the money or at least it's worth knowing where it's heading as this can help us make investment decisions. And Goldman Sachs recently pointed out that 31 percent of passive flows year to date have been into the ESG theme. Over coming weeks, we'll continue to watch for the biggest shifts in the data usage across all themes, particularly changes in momentum, to see if we can pick up on some of the trends before they reach the mainstream.