Why Everyone’s Talking About… Market Bubbles

A market bubble occurs when asset prices, such as stocks, real estate or commodities, rise significantly above their intrinsic values, driven primarily by speculation rather than fundamental factors. This surge in prices is typically fuelled by investor optimism, herd mentality and the expectation of further growth.

Eventually, however, investor sentiment shifts and the bubble bursts, leading to a sudden and sharp decline in prices. Investors may rush to sell their overvalued assets, with some recording a financial loss. In severe cases, a market bubble can have broader economic implications, such as a financial crisis or recession.

Ignoring the ‘tulip mania’ financial bubble of the 17th century, there are generally considered to have been three large bubbles since the 1960s that each concentrated global market capitalisation for a defined period of time.

First came the ‘Nifty Fifty’ stocks (1965–1972), during which around fifty very large American companies dominated the world in multiple sectors of activity (IBM, McDonalds, Coca-Cola, Xerox, and others), which made them essential in the eyes of savers – regardless of their price.

Then there was the Japanese bubble of the 1980s. Japan’s apparent dominance over the economic and financial world resulted in a gigantic shift in global capitalisation in favour of Japanese equities, which accounted for more than 40% of the MSCI World index in the late 1980s.

Finally, we witnessed the dot-com bubble of 1995–2000, which was driven not only by telecoms and information technology equities but also by all the major growth securities. Investors poured money into so-called ‘dot-com startups’, often with little regard for traditional valuation metrics. The bubble burst after investor sentiment shifted in early 2000, leading to a sharp decline in stock prices as many overvalued internet-based companies went bankrupt.

Identifying a market bubble can be challenging, but several key indicators can suggest that one is forming or already exists. Here are some of the signs:

• High prices relative to value: The price of an asset has risen significantly faster or higher than its underlying fundamentals suggest it’s worth.
• Excessive leverage and low interest rates: Investors have borrowed heavily to finance their investments, which can indicate heightened risk-taking and make them more vulnerable to a forced sell-off. Low interest rates or rate cuts may make it cheaper to borrow, catalysing this trend.
• Increased speculative activity: A surge in speculative activity, such as day trading, may show investors are more focused on short-term price movements rather than long-term fundamentals.
• Bullish sentiment: Investors exhibit extreme optimism or dismiss concerns about valuations or risks. This may be complemented by a rush of new buyers into the market due to perceptions of quick and easy wealth gains.

Some or all of these indicators were present during many historical market bubbles, including the Roaring 20s and the leadup to the Global Financial Crisis in 2007/8. However, today’s market is more commonly compared to the dot-com bubble of the late 1990s, when widespread internet access led to a rapid rise in the valuations of internet-based companies. While the dot-com bubble formed due to a belief in the revolutionary power of the internet, some sceptics have suggested a similar trend is now forming with the frenzy around generative AI.

There is little denying that markets have been distinctly bullish since the beginning of 2024, with the S&P500 closing at a record high in January before beating that same record just two months later.³ Much of this growth has been driven by the Magnificent Seven, the market cap of which has increased by more than 80% since January 2023.⁴

While these gains are impressive, a nuanced analysis indicates that we aren’t in bubble territory – at least not yet. Here’s why.

First, financial professionals have noted that valuations today appear less extravagant compared to just three years ago, when the meme stock saga was at its peak – perhaps the most obvious recent example of blatant overvaluation. Excitement is centred rather conservatively around established companies with solid profits, rather than a group of trendy shooting stars. Trailing price to earnings ratios indicate the Magnificent Seven are much more closely aligned with the broader market than they were three years ago, with some analysts even suggesting the companies are trading cheaply.⁵

Furthermore, when compared with past bubbles, there is relatively subdued amounts of margin debt in today’s market. Options activity, used as a barometer of speculative behaviour, is also average and while some new buyers have entered the market, their activity has been modest.

While investor consensus appears to be that we’re not yet in a market bubble, it’s important to understand what it would take to get there.

The first key factor is interest rates. Low rates mean it’s cheaper to borrow, which urage traders to invest capital and drive the market higher. The Federal Reserve is expected to deliver several rate cuts in 2024, a sea change compared to the higher-rate environment of recent years. Rate cuts may cause an influx of capital into the market, strengthening the bull run.

However, stronger than expected inflation may mean the Fed doesn’t deliver rate cuts or delivers fewer cuts than expected⁶. This pivot could fuel uncertainty in the economy, generating pressure to sell and a potential downturn.

The second factor is generative AI. While the Magnificent Seven are leading markets, a closer look at this group reveals more nuanced insights. The fortunes of these companies appear to be diverging, as Tesla and Apple slump while Nvidia and Meta Platforms surge.⁷ Nvidia, in particular, has seen its stock price increase by nearly 90% this year.⁸

The growth of Nvidia and Meta has been attributed to the companies’ investments in generative AI, which many financial professionals believe will revolutionise the workforce and the economy. However, if this new technology fails to live up to the hype, a considerable market correction may be on the cards.

Furthermore, it is not too early to take precautions against the record market concentration around just a few stocks. Indeed, it is this concentration that has ushered in the new issue of company-specific risk – a type of risk that has traditionally been highly diluted in major global stock indices, even during bubbles.

This issue of specific risk is beginning to take shape due to the fact that three of the Magnificent Seven – Tesla, Apple, and Google – have been falling in value on rising markets since the beginning of the year. For the time being, these drops in value have been more than offset by stellar performances from Nvidia and Meta, but there is no guarantee that this will continue.