What are the signs of a bubble? After a 30% rise in the S&P last year, without any huge surge of economic growth in the US or Europe and slowdowns in China, Brazil, and other major economies, one might expect a breather. But the continued upward rise of the global markets seems to say that animal spirits are still very much alive.
How much is too much? After all, stock prices generally do NOT move together with GDP numbers. They instead respond to corporate profits, which often benefit from a downturn that allows corporations to cut costs drastically, then a modest recovery that allows them to hold or raise prices. So the pattern is often one of profits being squeezed by rising costs and competition when the economy is going strong, and profits doing very well on the back of weak recoveries following recessions.
Still, one has to ask whether there are any signs that the party is getting carried away. One sign is the wave of M&A activity; another is the huge price paid for acquisitions such as WhatsApp? When a tiny firm with no assets or profits, except its user base, can change hands for nearly 20 billion dollars, one has to ask if things are getting out of hand.
But for me, one of the simplest signs of a market that is in an inflationary bubble is the response to news. In January, after losing steam, the market responded to news that the US Economy had grown in Q4 by over 3% was taken as great news – the recovery is underway! And stocks resumed their upward trajectory. Of course, those who looked closely noted that much of that growth was in inventories, and that the employment numbers looked weak. No matter, GDP numbers are over 3%, let’s bid higher and higher.
This week, the revised GDP numbers for the US in Q4 were released. As expected, the revision was downward — but it was a bigger downward revision than expected, to 2.4%. No matter — a silver lining can always be found. The decline was due to government shutdown, and bad weather, and other things that are all in the past. So let’s expect 3%+ growth going forward anyway! And bid the marker higher and higher!
Now of course the optimists may be right — more growth may follow. But none of this growth is making much of a dent in employment or wages, so purchasing power is stagnating. At some point, cost-cutting will reach its limits, and corporate profit growth will then be less impressive than it has been. Besides, as long as the party is going strong, who wants to be the first to leave the room?
But a word to the cautious — when the market goes up because growth is strong, AND because growth is weak, it is going up on faith, not facts. That is a sign of a bubble, and the higher it goes, the deeper it will eventually fall.