Characteristics of Bubbles: Are We in One?

Accidents occur on highways more than on crowded streets, and this applies more than ever to the equity markets

Characteristics of Bubbles: Are We in One?
Characteristics of Bubbles: Are We in One?
Naveen Chandramohan 06 August 2021

Over the last 10 years, the S&P 500 (Benchmark index in the US) made new highs eight times (beating the previous highs) and over the same period, the Nifty 50 (Nifty in India) made new highs four times. Every time, a stock market index touches new highs, it creates a sense of opportunity cost for investors who look for characteristics of a bubble. Today, with the global indices being at record highs, it’s no surprise that many investors have a characteristic of bubbles fresh in their memory.

At the peak of every boom and in the trough of every bust, Benjamin Graham’s immortal warning is validated yet again: “The investor’s chief problem — and even his worst enemy — is likely to be himself.” When many investors look for trends between today and the growth-stock bubble of the late 1990s, one similarity does emerge - the Internet has made it so easy for investors to pick their own pockets, instead of paying someone else to do it for them. Disintermediation — the bypassing of advisors and “full-service” brokers — had been underway for decades, but it reached near-perfection in the bubble years. Discount brokers like Charles Schwab arose in the 1970s, then mushroomed in the 1990s, enabling investors to cut out the traditional (and more costly) face-to-face relationship offered by firms like Merrill Lynch and Smith Barney. Index funds, run by faceless machines, dispensed with the notion of hiring a “superstar” to pick stocks. The trends today do rhyme with the past, and Covid and the lockdown has provided tailwinds for this today, with the evolution of Robinhood in the US, and discount brokers, platforms and the increased retail participation in India.

Once, that degree of freedom might have frightened investors, but the new Internet brokerages cleverly fostered what psychologists call “the illusion of control” — the belief that you are at your safest in an automobile when you are the driver.

Studying the Nifty returns, the returns of the index are in line with the Free cash flow growth of the underlying companies in the index – over the last 10 years, Nifty has compounded at 9.9 per cent IRR as against a CAGR of 11.2 per cent in cash flow growth of the underlying constituents. This gives credence to the fundamental growth story backing the returns of the constituent index. However, within this, there are pockets of exuberance building up within specific sectors and businesses today.

How can one evaluate a bubble?

Typically, there are six broad questions that I use to evaluate criteria that has tended to precede bubbles (which itself can last for 3-4 years).

  • How high are prices relative to traditional measures?
  • Are prices discounting unsustainable conditions?
  • How many new buyers have entered the market?
  • How broadly bullish is sentiment?
  • Are purchases being financed by high leverage?
  • Have buyers made exceptionally extended forward purchases to speculate or protect themselves against future price gains?

Today, one can look at the above and say 2-3 conditions do hold true, but the conditions do not yet predicate a bubble in the markets.

However, it is important to understand that valuations necessitate discipline around capital allocation. Today, more than ever, an investor needs to be prudent around allocating money into equities and focus on businesses which show growth rather than chase themes which have momentum. The maximum number of accidents are caused on highways rather than on crowded roads, and this applies more than ever today to the equity markets.

The author is founder and CEO, ITUS Capital

DISCLAIMER: Views expressed are the author’s own, and Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.