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Ongoing rally fuels bubble fears

January 26, 2021

Graph depicting the decline in S&P 500

Source: Standard and Poor’s

With the dizzying climb in GameStop as the latest exemplar, the ongoing rally in stock prices is fueling increasing concerns that a bubble may be developing. The S&P 500 has shot higher by more than 70 percent since bottoming last March, the best ten-month start to a bull market on record, and is now sporting a price/earnings ratio north of 30. More to the point, there have been several tell-tale signs of widespread exuberance, most notably the massive re-emergence of the retail investor and record trading volumes at online brokerages.

Bubbles are very difficult to discern in the moment, however, and this one would be playing out at an unusually early stage of the cycle. The crashes in 1929, 1987, and 2000 all came only after several years of robust gains (the same can be said for the housing market in the mid-2000s) and all were sustained for a time by the belief in economy-altering structural developments (autos and electrification in the 1920s, falling inflation and interest rates in the 1980s, the internet in the 1990s). There may not be an obvious driver to fuel a similar zeitgeist at the moment, but there are enough plausible candidates (unprecedented monetary and fiscal stimulus, an end to The Great Stagnation, etc.) to keep this cycle afloat for some time to come.

Most importantly, broad market bubbles have historically been popped only via restrictive monetary policy. The Fed lifted rates aggressively in the run-ups to the 1929, 1987, and 2000 peaks as well as prior to the housing market crash of a decade and a half ago. Over the last five decades, in fact, the S&P has never fallen into a new bear market prior to the first Fed tightening of an economic expansion, retreating by 20 percent or more only after at least five rate hikes in each case.

This is not to say that the interim period will not be choppy. Bull markets that get off to robust starts and that produce lofty valuations often also see heightened volatility – note the three quick corrections in the late 1990s and the record-tying five such pullbacks across the 2009-20 cycle, for example. With the Fed on an extended hold, however, a crash along the lines of those referenced above is very unlikely anytime soon. If this is truly a bubble, it is a good bet that it will grow much bigger before it runs its course given that the process by which it would end may still be several years from even getting started.

Daily Trivia

What central bank regularly adjusted benchmark rates by multiples of nine until the 2010s, in part to simplify interest calculations on an abacus?

Previous Question

What bestselling book traces its origins to a 2003 New York Times Magazine article entitled “The Probability that a Real-Estate Agent is Cheating You (and Other Riddles of Modern Life)”?

Answer:

Freakonomics

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