Quick Bite: Are we in Bubble Territory?
Author: Paul Zwi
The US equity markets’ correction, triggered by news of the DeepSeek model, has been the first fall of more than 3.5% of the Magnificent 7 since last year. Nvidia, the largest company in the world by market cap, lost 17% in a day – a staggering loss of half a trillion US dollars (USD). Was this a sign of a bubble bursting? Are we in the grips of an artificial intelligence (AI) inspired market narrative that is leading to, or has already led to, “irrational exuberance”? These are difficult questions, and no one can be certain until years after the fact, and in hindsight.
Spoiler alert: in my opinion, for what it is worth…probably not. But there is better value elsewhere.
Robert Shiller wrote his seminal book Irrational Exuberance in 2000, and it remains highly instructive.
“Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.”
“Just what is a speculative bubble? The Oxford English Dictionary defines a bubble as “anything fragile, unsubstantial, empty, or worthless; a deceptive show. From 17th c. onwards often applied to delusive commercial or financial schemes.” The problem is that words like show and scheme suggest a deliberate creation, rather than a widespread social phenomenon that is not directed by any central impresario.”
“In a broad sense, this book, from its first edition in 2000, has been about trying to understand the change in thinking of the people whose actions ultimately drive the markets. It is about the psychology of speculation, about the feedback mechanism that intensifies this psychology, about herd behavior that can spread through millions or even billions of people, and about the implications of such behavior for the economy and for our lives. Although the book originally focused directly on current economic events, it was, and is, about how errors of human judgment can infect even the smartest people, thanks to overconfidence, lack of attention to details, and excessive trust in the judgments of others, stemming from a failure to understand that others are not making independent judgments but are themselves following still others—the blind leading the blind.”
― Robert J. Shiller, Irrational Exuberance
As someone who has been investing, speculating, and even gambling in financial markets for 50 years, I have learned one or two things over that time that I can share with others.
- Be humble. Accept that you do not know everything. Markets are complex and driven by the psychology of crowds as well as by data.
- Avoid arrogance, and hedge your bets through sensible diversification.
- Take a long-term view. Short-term movements are inherently unpredictable.
So much for the sermonising!
Now let’s examine a few charts that can assist with our understanding of current market conditions. Note that some of these charts have been used previously, but remain relevant for providing historical context. I am grateful to Goldman Sachs for permitting me access to this material.
The first point is that global macro conditions remain favourable for financial markets. The US economy grew by 2.5% throughout 2024, and corporate earnings have been robust and likely to remain so. The US Federal Reserve (Fed) is still on course to cut rates although not as rapidly as previously hoped for. The low-hanging fruit has already been plucked, and it gets more difficult to cut from here.
In the US, we expect solid real GDP growth of around 2.6% in 2025, reflecting tailwinds from disposable household income growth and easing financial conditions amid continued rate cuts, with US growth likely to continue outpacing peers given its stronger productivity growth. We expect global core inflation to fall gradually to around 2.4% by end-2025.
In the Euro area, we expect below-par real GDP growth in 2025, reflecting continued structural headwinds in the manufacturing sector, trade policy uncertainty, and ongoing fiscal consolidation. The European Central Bank (ECB) will continue to cut rates. In China, we expect real GDP growth to slow to 4.5% in 2025 as the policy easing measures only partially offset weak domestic consumption, the ongoing property market downturn, and likely higher US tariffs.
Amid the announcements from the Trump Administration, uncertainty about tariff policy remains high, with tariffs likely to impact growth and inflation, and with larger growth drags in Europe and China. Geopolitical risk remains high as we watch the situation in the Middle East, Russia-Ukraine, and the US-China relationship.
The current combination of macro conditions has historically been supportive of risk assets: Global equities around the Fed cut with and without a recession.
Source: Goldman Sachs
Bear markets are usually triggered by expectations of falling profits driven by fears of recession. Most economists remain confident about world growth and their forecasts for the US, putting the probability of recession in the next 12 months at around 15%.
Note however that equity markets, particularly in the US, are priced for perfection, leaving them vulnerable to disappointments. When I started on the Johannesburg Stock Exchange back in the 1980s, the old wags used to say, “If you are dancing on the mountaintop and you stumble, there’s a long way to fall.” I keep that in mind, and Nvidia’s drop was a good example.
Returns in equity markets, led by the US, have been unusually strong over the past couple of years, particularly since October 2023 as investors became more optimistic about the prospects for lower inflation and interest rates alongside a soft landing.
Returns in equity markets, led by the US, have been unusually strong over the past couple of years, particularly since October 2023. 2-year calendarized S&P 500 performance starting in January. Data since 1928.
Source: Goldman Sachs
Overall levels of valuations have reached very high levels, particularly in the US, and price-to-earnings (P/E) multiples have increased meaningfully. In the case of the US, while much of this reflects the largest technology companies, the equity market remains expensive relative to history even if excluding large-cap tech. Furthermore, while other equity markets around the world are much cheaper than the US, most are not particularly cheap relative to their history. The main exceptions are China and the UK, which are cheap (but for good reasons).
Source: Goldman Sachs
The final charts show the dominance of technology on market returns, reflecting the significant outpacing of technology profits relative to other industries over the same period.
12m Trailing EPS (USD). Indexed to 100 on Jan-2009.
Source: Goldman Sachs
One can examine the performance of the tech sector, and the track record of the Magnificent 7 with some trepidation – but one must acknowledge the function of their vastly superior earnings power over the past decade. I well remember the tech boom of 2000; there was much “blue sky” and nonsensical business models that prevailed at the time, startup companies that had no hope of ever being robust businesses. The current interest in the mega-tech stocks is vastly different – these are truly world-beating robust businesses with exceptional track records of growth and innovation that are incredibly profitable and virtually impregnable balance sheets.
Source: Goldman Sachs
Is this a bubble? It does not look like it to me, but it is a very expensive market – particularly in US technology. Investors should probably be looking elsewhere if they are interested in value and a good night’s sleep. A sensible place to start might be 3 sectors on the ASX that are benefitting from the low AUD at present – energy, materials, and healthcare.
