Time to pause? Wall Street grows wary of some stock bubbles

Wall Street is abuzz about stock market bubbles as surges in the share prices of some loss-making firms, red-hot public markets and amateur investors chasing stocks at frothy valuations spark fears of a pullback.

A flood of money supply, ultra-low or zero interest rates and Covid-19 vaccine rollouts have sparked a 'buy everything' rally, helping world stocks add a whopping $33 trillion in value from their lows of last March.

The euphoria is evident in the small cap Russell 2000 index where its component companies with a negative operating profit outperformed the wider index by nearly 50 percentage points over the last year, a Reuters analysis of Refinitiv data showed.

"Pockets of the market have recently demonstrated investor behavior consistent with bubble-like sentiment," Goldman Sachs analysts led by David Kostin wrote in a note.

Goldman noted the outperformance of negative earners was still a far cry from the 140 percentage points clocked during the dotcom boom of 1999-2000 and more in line with that of the immediate aftermath of the 2008 financial crisis.

While that might be of some comfort to investors, JPMorgan equity strategist Mislav Matejka expects "hot" areas of financial markets could be subject to bouts of profit taking which could spread to equity indices.

However, he said, those dips could be buying opportunities.

Stock valuations have soared to levels not seen since the early 2000s, but this has not caused investors major concern as interest rates are at record lows backed by pledges to keep them there until a recovery is firmly established.

For examples of these selective bubbles, look at electric vehicle-related stocks - Tesla is up 8-fold and electric vehicle charging equipment maker Blink Charging by 2000 per cent in the last 52 weeks, while an IPO index has surged 200 per cent since last March versus a mere 57 per cent for the benchmark S&P 500 index.

Elevated retail participation has contributed to soaring prices. Retail broker eToro told Reuters it registered more than 380,000 new users in the first 11 days of 2021.

US videogame retailer GameStop's 50 per cent jump on Monday, on top of 250 per cent year-to-date, was attributed by traders to short-sellers quickly buying back into the stock to cover potential losses, defined as a short-squeeze, and retail investors piling in to benefit from the surge.

Ninety percent of the respondents in a recent survey by Deutsche Bank said they saw price bubbles in some parts of markets, with a majority expecting Tesla to halve in value by the end of 2021.

Bubbles Don’t Burst Easily

However, not all the major banks see bubbles.

"Everyone's asking us about bubbles... even the frothiest equity indices still lag well behind performance during previous bubbles," said Robert Buckland, Citi equity strategist.

For example, the S&P trades at 22 times 12-month forward earnings, below the peak of 25 times seen ahead of the dotcom crisis.

Citing premia over rock-bottom bond yields, Citi believes equity markets have a long way to go yet.

At just over 1 per cent, the yield on the Bloomberg Barclays Multiverse index of 10-year government and corporate bonds worldwide is the lowest in the 22-year history of the index - less than half the rate of just two years ago and compared with 6.2 per cent at the height of the dotcom bubble.

A rollback of US Federal Reserve easing is seen as a threat to markets but there is no signal of that yet from the central bank.

"Equity bubbles are not delicate," Buckland added.

"They don’t burst on the first hint of tightening from central banks. They are run-away trains that misallocate capital, reshape the investment industry and end careers. They take some stopping."

What's more, for all the signs of speculative excess from hedge fund and investor sentiment surveys - cash stashed in money market funds or in household or corporate savings is still far higher than before the pandemic emerged.

"The picture is nuanced – heavy activity in certain stocks and options, but less extreme overall investment flows," Morgan Stanley's cross-asset strategist Andrew Sheets told clients.

"Hedge funds appear optimistic, but many businesses and individuals are still keeping cash on the sidelines given the uncertainty."