32.9%, that was the contraction of the United States’ economy during the second quarter of 2020 due to Covi-19. This announcement, combined with a rising unemployment to 11.1 percent and highest bankruptcy rates since the financial crisis 2008, such announcement raised gloomy concerns for the stock market. While the stock market was expected to crash, it nevertheless boomed despite all the economic challenges.
In fact, over the last four months, the stock market has actually had one of its best four-month periods in history as it witnessed some of the most rapid gains in history. Many have attributed this unusual performance to extraordinary circumstances, and to a novel nature of the existing market and economy. Yet, other experts in the field are contend this explanation. In fact, there’s a minor percentage of investors who claim to have seen this strange pattern a few times before. For example, in the year 1993, a new technology called Web Browsers (at that time) started gaining popularity around the world. These web browsers, or more specifically the Mosaic web browser, allowed for the average computer user to connect to the internet in a simple and straightforward manner for the first time in human history. It was this technology that helped lead to the expansion of the internet and the growth of computers throughout the 1990s, and this growth was so massive that from 1990 to 1997 the computer ownership rate more than doubled from 15% to 35%.
From 1995 to 1999, the number of Internet users grew from just 15 million to over 260 million. Essentially investors could feel the wave of a new economy coming forward. With upstart companies like Amazon selling books over the internet and eBay selling almost anything else, investors became extremely excited regarding this new type of economy. Moreover, during this time, the economy witnessed one of the biggest cuts to interest rates; from 1989 to 1993 interest rates fell from 9.8% to just 2.9%. This meant that investors could access capital much easier than they could just four years before. Add to that, the cherry on top, was that there was a significant tax reform in the year 1997, which cut taxes on capital gains. It was these three factors that led to one of the most staggering periods that the stock market had ever seen.
To put into perspective how impressive this period is, it is crucial to study the usual experience that an investor would typically face. Normally if an investor invests in the stock market, in ordinary situations he would expect a five to ten percent return per year. But if an average investor started investing in the stock market in October of 1990, he would have seen on average a rate of return of about 39% per year for the next 10 years. And if this investor had invested heavily in the tech sector (at that time) with an index like the NASDAQ, he would have seen on average returns of about a 111.8% per year from 1990 up until the year 2000. Also put in perspective, if this investor would have invested $100,000 into the tech sector in 1990 and simply held his investments for about a decade, his portfolio would have been worth 1.1 million dollars.
However, this appreciation in the tech sector and the stock market as a whole is not only explained by the influx of new companies that were accumulating billions of dollars of profits. It was mainly because there was an influx of new tech companies that got investors excited, but even more importantly, there was an influx of new investment capital due to the increasing motivation brought by the new economy along and incentivized by the low interest rates and tax cuts.
In this regards, the PE Ratio is a metrics used to evaluate how overvalued the stock market is. This metrics compares the price of a stock to its earnings per share. Even though the value of a company is a lot more complex than a simple PE ratio, the metric is a good general indicator for determining if a stock is overvalued.
Putting this metrics into action, in 1990 the average PE ratio of the S&P 500 index was about 15, which was close to the average PE ratio for the last several decades. However, after the influx of new capital that started flooding the stock market in the 1990s, the average PE ratio on the S&P 500 jumped up to over 30. All this meant that the average company had doubled its value in relation to its earnings or profits from the year 1992 the year 2000. During that period, it was very common to hear stories from family and friends and from the mainstream news about people getting very interested in investing and trading in the stock market to try and take advantage and make gains. This can’t help but draw parallels to today!
Today, if we do a quick web search on the popularity of a search term like “stock market investing”, we will see that there is more than double the amount of searches for stock market investing on a daily basis, than there were on average for the previous eight years. Add to that, the United States cut interest rates to almost 0%. Again, drawing at least some parallels to what happened in the 1990s.
However, it is worth mentioning that the market today is quite different from the market in the 1990s; in the sense that investors today are looking to make money from established companies versus investors investing heavily into companies with no profits in the 1990s. Moreover, today, the Federal Reserve is doing everything it can to prevent the market from crashing. All what was mentioned trigger us in a way or another to believe that we may be experiencing a risky stock market bubble.
In the 1990s, we saw such a bubble in the stock market and mainly in the tech sector. In the 2000s, we saw it in the real estate market when it became significantly easier to get capital from banks, confidence in the real estate market was at an all-time high. Real estate prices increased by over 35% from 2004 to 2007. This wasn’t because the average person got 35% richer, or any other hard economic indicators backing up the 35% increase. Simply, it was because an asset bubble was being created.
A more recent example was the Bitcoin bubble of 2017, where the price of Bitcoin increased by about 370% percent from September of 2017 to January of 2018, yet the utility and application of Bitcoin only increased by about 10 to 20% during that time.
Extremely interesting and worth mentioning as well is that all of the mentioned bubbles have been predicted by “Google Trends”. In few simple steps anyone can study such trends, for example one can go onto “Google Trends” and look for search volumes of assets. If any sort of spike appears in the search volume of an asset that it almost always correlates with a rapid increase in price, then this indicates that it may turn into a bubble.
One of the troubling things about this stock market is that even if you include the stock market crash that happened in March, there hasn’t even been a slight decrease in the value of the stock market; meaning that despite the economy being in the worst shape in generations, the stock market is relatively booming compared to the economy. And even though the stock market has never been directly correlated with the health of an economy, it is at the very least supposed to be a derivative of the economy.
One key thing that might point towards the stock market going through a correction or a crash soon, is the action that banks are taking in order to prepare for a significant downturn in the market within the next 12 months. JPMorgan for example, just had a record earnings report, however, in its second quarter of this year, its stock fell. That is because it announced it is setting aside a huge amount of 10.5 billion dollars in cash to help mitigate any future downturn in the economy. In fact, the company said that there is an increasing uncertainty about the economy and the stock market and that they expect to see nearly double digit unemployment for the next 12 months. If that were to happen, we could easily expect more defaults on real estate loans, small business loans, and corporate loans, all of which would be a big hit to the banks which could in turn make the financial sector collapse in a similar fashion to how it collapsed in 2008. Consequently, If the financial sector were to collapse, then the stock would likely collapse as well!
To clarify this point, we take the example of Apple. When it comes to Apple’s largest shareholders, it is not Co-Founder Steve Wozniak, neither current CEO Tim Cook (who only owns about 0.02% of Apple), and definitely not the late Steve Jobs or his family. In fact, the largest shareholders of Apple are actually Vanguard, Black Rock, Berkshire Hathaway and State Street Global Advisors Funds (SSGA Funds). These are investment companies and own a quarter of the company’s shares. This means that if these banks were to experience the downturn, than they might sell a large portion of their Apple share, which would eventually cause the price of Apple to collapse.
The above-mentioned example of the banks owning Apple applies to virtually every other company on the S&P 500. So as soon as the banks go downhill, so will the stock market leading to a similar trend to what we saw during the Great Depression.
In this regards, Jamie Dimon, who is the CEO of JPMorgan, announced that the recessionary part of this crisis is actually still down the road. Meaning that one of the top investment bankers in the world expects the economy to be bad for quite a long time and that might eventually reflect through the stock market.
We are living in uncertain times combined with the risks brought about by the uncertainties from an upcoming US elections. In its turn, the Federal Reserve is doing everything it can to prevent the market from collapsing and most major countries around the world are taking on a massive amount of debt in order to try and prevent an economic crash. Bottom-line, even if it seems that the stock market is fine right now, it is quite possible that we are in the middle of a bubble and we just don’t know it yet.
