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UBS strategists say six of the eight signs of a stock bubble are already flashing.
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The generative AI hype has driven stock prices to record highs, raising fears of bubbles.
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Current conditions reflect those of 1997, not 1999, suggesting a bubble could emerge soon.
There has been a lot of talk about the stock market being in a bubble over the past year as the hype for generative artificial intelligence drives stock prices to record highs.
In a recent note from UBS, strategist Andrew Garthwaite outlined the eight warning signs of a stock bubble – and according to Garthwaite, six are already flashing.
That means the stock market isn’t in a bubble yet, but it could be soon.
“The upside risk is that we enter a bubble. If we are in that situation, we think it will be similar to 1997 and not 1999,” Garthwaite said.
That’s important because stock market bubbles often lead to a painful 80% drop once they burst, but Garthwaite says we’re not there yet.
“We only invest for the bubble thesis if we are in 1997 and not 1999 (which we think it is),” Garthwaite said.
These are the eight warning signs in the stock market, according to Garthwaite.
1. The end of a structural bull market – Flashed
“Bubbles tend to occur when historical stock returns have been very high compared to bond returns and so investors extrapolate historical returns as predictors of future returns – while future returns, as reflected in the ERP, are significantly below their norms,” said Garthwaite . said.
2. When Profits Are Under Pressure – Flashed
While the S&P 500’s earnings have soared over the past year, there’s another measure of corporate earnings that investors should keep an eye on.
NIPA earnings measure the profitability of all companies, including private companies, and if these differ from the profits of publicly traded companies, investors should take this into account.
“We can see this if we look at the TMT period where NIPA profits fell while stock market profits rose. The same was true in Japan in the late 1980s,” Garthwaite said.
3. Major loss of width – Flashed
When the stock market is extremely concentrated in a handful of companies that account for the majority of profits, that’s a sign that breadth is weak.
With a record concentration in the mega-cap tech stocks, that is exactly what has happened as the average stocks fail to deliver strong returns.
“We can especially see this when we look at the rise to fall versus the S&P 500 during the TMT period,” Garthwaite said.
4. Needs a 25 year gap from the previous bubble – Flashed
“This allows a whole group of investors to believe that this time is different and to develop theories that stocks should be at a structurally lower ERP,” Garthwaite said.
5. Has a 25 year gap from the previous bubble – Flashed
“This story is either about dominance or, more typically, technology. In the 19th century there was a bubble linked to the railways and in the 20th century there was a bubble leading up to 1929 linked to the mass production of cars, electrification. of cities and radio,” Garthwaite said.
6. Retail Begins to Participate Aggressively – Flashed
When retail investors aggressively buy into the stock market, the equity risk premium can drop to very low levels, leading to sky-high valuations.
“There is evidence of this, such as the bull/bear ratio of individual investors being very high compared to the norm,” Garthwaite said.
7. Too loose monetary policy – Has had no effect
Previous bubbles emerged when real interest rates fell sharply. That hasn’t happened yet because the Federal Reserve hasn’t cut interest rates yet.
“Current monetary conditions look abnormally tight compared to the output gap,” Garthwaite said.
8. Extended period of limited declines – Did not flash
Previous stock market bubbles have seen multi-year periods of limited sell-offs of less than 20%.
With the S&P 500 experiencing a painful bear market in 2022 and selling off more than 25% at its lows, there may still be a long way to go before this condition is met.
Read the original article on Business Insider
