(BFM Bourse) – The bubble phenomenon on the markets has occurred several times in the past. While there is no foolproof method for detecting it, signs can encourage caution.
It’s a recurring question in a bull market: are we witnessing the creation of a stock market bubble? Investors’ enthusiasm for the promises of generative artificial intelligence or for anti-obesity drugs has revived these questions without the debate being resolved.
But what is a bubble anyway? According to a definition agreed upon by Natixis and CMC Markets, a bubble occurs when asset prices, such as stocks, bonds or commodities, rise to the point where these prices significantly exceed their “intrinsic” value (which would be defined, for example, by fundamentals, such as supply and demand).
This rise is thus generated by pure speculation rather than by fundamentals. In other words, the market is buying because everyone is buying and is afraid of missing out. “This surge in prices is generally fueled by investor optimism, a herd mentality and the expectation of new growth,” explains Natixis. These bubbles can concern the entire market or a sector as a whole, recalls CMC Markets.
Among the most famous bubbles, let us mention the one from the 17th century which concerned… tulip bulbs. The flower, prized for its rarity and prestige, in fact led to a speculative frenzy, to the point where a bulb was worth, at the peak of the bubble, the equivalent of two houses in Amsterdam. Other examples of more recent bubbles: the “nifty fifty”, this period from 1965 to 1972 and during which fifty large American capitalizations (Coca, Xerox, McDonald’s, IBM) were considered essential regardless of their prices, or the internet bubble from 1995 to 2000.
When “a new paradigm” appears
How can we detect these bubbles in the stock market and thus prepare for a market crash when the said bubble bursts? Let’s say it right away: there is no foolproof method. Otherwise everyone would sell their positions at the slightest appearance of a semblance of a bubble which would not have time to form.
“A crash cannot be anticipated, by construction, otherwise it does not occur,” recalled Julien Nebenzahl, director of savings solutions at Etoro, on Monday in the program “Tout pourinvestir” on BFM Business. We only really recognize a bubble “when it begins to deflate,” he added.
However, there are some signals to watch out for. Julien Nebenzahl points out a bundle of clues listed by the famous economist John Kenneth Galbraith, often cited as a potential winner of the Nobel Prize in Economics and who died in 2006.
The market expert explains that a bubble has as its “subject” (internet, tulip, artificial intelligence…) something that is described as “a new paradigm, a real revolution, a new world”. Then, explains Julien Nebenzahl, experts tend to explain to investors that the subject of the bubble is incomprehensible but that it is still necessary to invest in this theme. Thirdly, bubbles are often accompanied by “leverage mechanisms”, he recalls. That is to say, investors tend to borrow to invest and thus multiply their positions and their potential gains.
Julien Nebenzahl believes that generative AI and Nvidia tick the first two of these three boxes and suspects that the third is likely to be reached. Many other experts believe, on the contrary, that this theme (Nvidia and by derivation, generative AI) is far from constituting a speculative bubble.
“If we look only at Nvidia’s numbers and its customers’ outlook, it’s hard to see how AI is a bubble. It’s more of an opportunity,” Christopher Dembik of Pictet AM said in early August. “We believe the technology sector is not in a bubble and should continue to dominate returns,” Goldman Sachs added in a note published last week.
Valuations to watch
To return to the characterization of a bubble, CMC Markets cites several elements. First of all, an abnormally positive market sentiment, with generalized optimism, ranging from analysts to the press to company directors. Then “stretched” valuations, that is to say that stock market prices are evolving at peaks in terms of multiples of revenues or profits and thus arrive at levels that are difficult to justify in view of their fundamentals. Or even an “irrational exuberance” with herd-like behavior where investors position themselves simply for fear of missing an opportunity.
CMC lists some indicators to watch for these warning signs, such as the “PER” (price-to-earnings ratio), which is the number of times a stock trades its earnings per share. The higher this ratio, the more likely a stock is to be overvalued. Or the VIX index, a measure of market volatility, a sudden increase calling for caution. Or even simply the Warren Buffett index, named after the famous financier, which measures the total valuation of the American market in relation to American GDP.
Natixis, for its part, also urges monitoring of asset prices and being wary of an overly optimistic market mood that would show that investors are no longer taking risks and valuations into account. The bank also recommends monitoring “speculative interest” with abnormally high volumes on a stock or on the market.
“An increase in speculative activity, such as day trading, may indicate that investors are focusing more on short-term price movements than on long-term fundamentals,” the bank concludes.
Julien Marion – ©2024 BFM Bourse
