Bubble-Hunters Are Missing A Change In Incentives

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by Tyler Durden
Wednesday, Nov 17, 2021 - 09:00 PM

By Michael Read, macro strategist for Bloomberg's Markets Live blog

 It is fairly simple to find froth in equity index-levels based on arbitrary historical comparisons, but, despite warnings from the Federal Reserve, bubble-hunters may be missing a key new ingredient: the forced increase in risk appetite.

Analysis of history’s market-bubble implosions shows a few common features including:

  • A persistent upward trend in prices despite negative news flow

  • A narrative that captures the market’s imagination (think “house prices never decline”)

  • Increasing retail participation

  • Equity valuations in top percentiles

Naturally, you could tick some of those boxes while mentally drifting into this-time-is-different territory even if there are pockets of relative value. You’d certainly be forgiven for thinking that fundamental analysts are a dying breed in the current investing landscape.

Textbooks tell you that stock prices should not deviate excessively from some discounted measure of expected cash flows. However, nearly two-years after Covid-19 entered the common lexicon you would have missed out catastrophically if you’d balked at P/E, EV/EBITDA or other such ratios.

The pandemic has exacerbated what was a creeping change in the investor psyche. While the playing field has been leveled by zero-commission trades and gargantuan shifts in trading technology, it’s the mental game that has really been flipped on its head.

Zero- or negative-interest-rate policy has left the average individual unable to save for retirement by “normal” means. Unless you own property, have inherited wealth or draw a very healthy salary you’re a bit stumped -- and forced further up Markowitz’s efficient frontier.

The greater propensity for self-directed trading -- where individuals buy what they’re familiar with or something with potential for exponential growth -- has seriously dented the appeal of passive investing or more prudent slow-and-steady portfolio gains.

That said, it’s not just the narrative. If real rates remain negative then there really is no other option but to be long risk. Combine that with the potential for a period of elevated inflation, and money will have to move to anything offering yield or expected capital gains, or run the risk of a substantial regressive tax on wealth.

Much of the above might scream “bubble.” However, in the coming twelve months, can you envisage an equity draw-down of equal or greater magnitude than when the global economy was switched off in 2020? If so, can you envision any alternative to the rampant bullishness we witnessed in the aftermath?

We are likely to remain in a prolonged pro-risk environment, underpinned by the speculative trader. Of course it will come with periods of elevated volatility and greater options play by retail, with niche areas like crypto and ESG drawn into the mainstream.

Balance sheets are getting stronger, dividend payouts higher and boardrooms more confident. While cash holdings may be on the rise and equity-derivative downside-hedged to the greatest levels on record, it will be super easy financial conditions, cautiously supportive fiscal policy and the nascent belief that central banks will not quash the post-pandemic recovery (even when rates eventually rise) that will keep the pro-risk mood music playing.