What is the Hallmark of a Financial Bubble?
There are many signs that we may be in the middle of another financial bubble. One of those signs may prove that we are.
The recent IPO of Robinhood (ticker: HOOD) - the platform that has been instrumental in creating the current populist stock market zeitgeist and has helped spawn speculative “meme” stocks such as GameStop and AMC - seems like an appropriate occasion to ask whether or not we are in the middle of another financial bubble.
This is especially true given the sort of circular (dare we say Ponzi-like?) nature of this equity offering: the IPO is itself the kind of transaction that helped propel the Company’s growth and enabled it to go public in the first place - because the Company’s users subscribed to a significant portion of the offering (the plan was for up to 35%) through the Company’s very own platform.
In other words: the Company has grown by encouraging inexperienced traders to speculate in the financial markets through its game-like app and has now gotten those same inexperienced traders to speculate in the Company’s own stock through that very same app (you can’t make this up). That is why this IPO looks and feels like the kind of “what were we thinking?” transaction that could eventually be seen as the moment that the meme-stock mob effectively “rang the bell at the top of the market” (to paraphrase a Wall Street saying). Perhaps Robinhood will ultimately be similar to pets.com: a company that comes to forever symbolize a particular era of financial hubris.
Of course the Robinhood IPO is just one transaction and any particular securities offering can be egregious, even in markets that are generally priced appropriately. So besides the Robinhood IPO, are there any other signs that we are in a financial bubble?
Consider just a few:
Both fixed-income and equity securities are extremely expensive by almost any measure (in fact corporate bonds may be more expensive than ever).
There is a large aggregate market capitalization of publicly-traded companies that have never made a significant profit and thus still have unproven business models - in spite of having been in business for years, e.g., TSLA, UBER and LYFT.
There are new companies with outright outlandish aspirations or business plans, e.g., here is the second sentence from WeWork’s S-1: “Our mission is to elevate the world’s consciousness.” (to be fair the WeWork IPO was a spectacular failure - but still!)
Retail investor participation in the markets has been very high (thanks in part to the aforementioned Robinhood).
The action in the markets has been getting a lot of attention within pop culture.
Buy-side professionals have come up with a new phrase to try and justify their decisions to buy overpriced securities: “there is no alternative” or “TINA” (in the “dot-com” era it was phrases like “new economy v. old economy”).
“SPACs” or “blank-check” companies have re-emerged (few people seem to remember that the last time they were active was in the period leading up to the 2008-2009 crash).
The emergence of the pure trend-following fund complex ARK (back in the “dot-com” era it was Janus).
The high-profile failure of Archegos (back in 2007 it was the Bear Stearns hedge funds).
The existence of “zombie” companies that are incapable of earning an acceptable return on capital but can still raise money.
This list could easily be expanded to include any number of recent signs of “bubble-like” activity. But therein lies the problem: no matter how long we make such a list, the sheer number of items on that list could never really prove that we are in a financial bubble. At best it could establish what a lawyer might refer to as a “fact pattern:” a mosaic of facts that all point in the same direction and thus strongly suggest a certain conclusion. So even though many investors have compiled interesting “bubble checklists” (some of which are quite thoughtful) such lists may not provide the kind of conviction that is useful for investment decision-making.
I submit that there is a much more straightforward way to identify a financial bubble: directly. The most direct or prima facie sign of a bubble is the emergence of a relatively large market (as measured by total market capitalization) in financial instruments that may have absolutely no value at all. By definition the activity in such a market represents pure, unadulterated speculation - the kind that has the potential to wipe out practically everyone who remains in that market. What we are talking about here is not like flipping a coin: it is more like betting that a coin will somehow ultimately come up heads when both sides have been stamped tails.
This then may be the hallmark of a financial bubble. The significance of the existence of such a market is much easier to interpret than, say, the significance of a stock market in which investors are wildly overpaying for S&P 500 companies. In the case of wildly overpriced S&P 500 stocks, traders are paying prices that are much higher than are justified by company fundamentals and so they may end up taking big losses but will nonetheless end up owning something of real value. In the case of a purely speculative market, traders could experience total losses and could end up “owning” something that literally has no value.
These purely speculative markets are only limited by the imaginations of their creators. In the “dot-com” era (leading up to the crash in 2000) it was the market for “dot-com” stocks of companies that had little more to offer than the phrase “dot-com” in their name. In the “subprime” era (leading up to the crash in 2008-2009) it was the market for the junior tranches of subprime mortgage securitizations. And in our current era it is the $1.5 trillion “cryptocurrency” market.
This then may be the surest sign that we are in a financial bubble: there is now a significant market for financial instruments such as “Dogecoin” (which one funny comedian has pegged as “Dog Money”). And even if such a market is somehow “ring-fenced” - in the sense that it could crash without bringing down the rest of the financial markets - the fact remains: the “cryptocurrency” market is a direct indicator of the current general appetite for speculation across the financial markets.
Only time will reveal the fate of the current “boom” in financial markets. But if it does goes “bust” the current speculation in “cryptocurrency” may prove to have been the most direct and obvious clue that a financial bubble is now staring us right in the face. To paraphrase Sherlock Holmes: sometimes the most obvious signs are the most elusive.