Is This Another Market Bubble?

There is unquestionably a lot of hype in the financial markets at the moment, mostly (but not entirely) centered on the theme of AI and a new wave of innovation. AI is exactly the sort of technological development that easily captures investors’ imaginations and is therefore a perfect candidate for building the kind of euphoria that often drives markets into bubble territory. Against this background and with currently high equity market valuations, investors are right to be wary of what kind of future returns they should expect.

What is not clear, however, is whether this is a bubble, which by definition is a prelude to a major crash. Spotting widespread bubbles is not easy; if it were, they likely wouldn’t exist. Yet, if we use Kindelberger’s simple definition of what constitutes a bubble, the current market does not seem to fully qualify just yet. While the acuteness of the price increase exiting the pandemic was sharp, the current market return from the three-year low is at the historical average, and returns have not been on the same scale as past pure equity market bubbles.

Meanwhile, gazing across a number of different valuation metrics, it is fair to say that the equity market is relatively expensive across most. Looking backward, many of the companies driving these gains have been delivering on these expectations, and profit margins up to now have been structurally higher—i.e., the numbers have backed up the narrative. This most definitely did not occur with the “concept” stocks of the late 1990s, which were mostly all narrative and no numbers.

Using more forward-looking valuation metrics, such as the implied ERP, investors seem optimistic and are demanding a premium on the low end of what they have been asking for over the past decade; however, looking back to the early 1960s, the current premium exactly matches this historical average, and it is nowhere near the lows reached around the peak of the internet bubble in 1999.

Lastly, with so many who experienced the aftermaths of the internet and GFC bubbles still working in financial markets today, there is likely to be a fair amount of recency bias among investors—everyone is keen to spot the next bubble and avoid it (particularly given current aging demographics where there will be a lower willingness and ability to take on risk)—which may also be a helpful limiting factor in preventing one.

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