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The Final Fuse

President Biden wants to approve a new stimulus package to inject an additional $1.9 trillion, including a $1,400 cheque for most tax-paying Americans. His approach to push more liquidity into the economy is a counter-effective idea. We are experiencing an economic crisis of demand, which cannot be fixed by injecting additional cash. According to The Economist, a large part of the initial stimulus checks went into savings rather than being spent on consumption. What will happen instead is further destabilization. People’s behaviour does not change in the short term, and attempting to boost the economy with cheap liquidity will not be successful. The prior stimulus has already created numerous bubbles in the stock market. Is this additional stimulus needed? Too much growth can be a bad thing as it goes hand in hand with increased inflation, higher interest rates, surging commodity prices and rising housing prices. There is also a discussion of whether or not to increase the minimum hourly wage to $15, which can also further fuel the fire in this overheated and overleveraged economy in a pandemic.

Young and inexperienced investors ploughed these savings into brokerages such as Robinhood, as can be seen by the increased volume of deposits opened around the date the stimulus cheques went out. The investments made by these ambitious traders are mostly in high-risk stocks or magnified trades using margins and options.

The additional stimulus could speed up the seriousness of bubble formation to the point where it reaches a potentially critical level. The bubble then becomes too big to maintain and crashes down. Over the last few years, the Federal Reserve has already prompted investors to take risks due to the incredibly low yield levels on long term debt, making it a bad investment decision. The hype to make “easy, quick money” on the stock market with high risk, high return trades are visible on social media platforms such as Reddit’s r/Wallstreetbets, where a cult-like following exists. Here, investors act more like gamblers and are encouraged to risk it all for the ‘tendies‘ (gains from investments). The combination of easy access and Robinhood’s zero percent commission allows anyone to participate in the financial markets. The downside of this is that it will enable the retail trader to take part in a lot of questionable behaviour.

Bubbles occur when the price of financial assets, stocks, cryptocurrency (or tulips)exceeds its fundamental value by a large margin. The asset’s rise in price is driven by high demand and hype levels instead of intrinsic value. This inflates the given asset class causing it to rise exponentially. The asset class then becomes very unstable and will inevitably pop, after which panic will lead to a disastrous crash.

Tulipmania was the first recorded market bubble. In the 17th century, Holland was an economic powerhouse, and the growing upper-class fell in love with the tulip, an exotic and beautiful plant. The wealthy sought the rarest bulbs and began to cross-breed them to create even more spectacular tulips. It soon became a symbol of status and luxury. As demand grew, tulip brokerages set up, and more people joined in on the trend. Professional traders saw opportunities to profit from this as anyone that possessed rare bulbs could make money as prices continued to skyrocket. Due to this, derivative trading and futures markets were created in which investors could buy more tulips with leveraged contracts. At the height of the mania, the price of one bulb could buy you a house on an Amsterdam canal. This all came to an end by late 1637, when the market collapsed as prices reached such levels that people could not afford even the cheapest bulbs. This sudden decrease in demand dropped prices dramatically to a tenth and then even more until the price reflected the intrinsic value of the flower. One big reason for the rapid decline was that many people had taken up loans to buy more tulips and create more wealth. This backfired as the prices declined, and many investors were declared bankrupt and had to liquidate their tulip portfolios at the closest market price.

Although the formation was studied by, for example, the economist Hyman P. Minsky, his work was overlooked for decades until the credit crisis of 2008-09. Mr Minsky was one of the first economists that saw and could explain the development of financial instability. He outlined the five steps of a bubble as a guideline before it becomes too late. First, investors are always looking for new innovative technologies that will be groundbreaking or investments that are “the next big thing”. This displacement usually starts slowly as more and more participants gain interest. Next, prices begin to rise slowly but gain more momentum as the “boom” develops, so more people join the market. This, in turn, causes widespread media coverage, and more people get involved. The fear of missing out (FOMO) causes more interest as people want a piece of the money pie. Euphoria begins to seep into previously rational investors, and in this phase, all valuations, caution and rationality are thrown out of the window as the asset price skyrockets. This is where the “greater fool theory” comes into play: a mechanism where you convince yourself it’s okay to invest in something even if you don’t believe in it because there will always be someone willing to pay a higher price. However, institutional investors and more risk-averse individuals start extracting profits at the first sign of decreased momentum. The slightest prick can cause panic and bring the hyperinflated asset to come crashing down. This leads to investors frantically starting to dump their holdings as prices plunge fast. The severity of the selloff is exacerbated due to the panic caused, bringing in an overwhelming supply of the asset and a decrease in demand.

Recently a methodology to measure current market conditions compared to previous bubbles was published by Bridgewater Associates: the so-called “bubble indicator”. They attempt to answer the following five questions. First, how high is the price relative to traditional measures? Next, are these prices discounting any unstable market conditions? It is also essential to see how many new buyers have entered the market and whether the bullish sentiment is broad enough to be adopted by all participants. Are purchases financed by high leverage and have the buyers made exceptionally extended forwarded purchases? This is usually high-risk, high-return behaviour synonymous over history with bubble formation. Each of these six influences uses several data points and are combined to create gauges for each stock. The collection of stocks is combined into aggregate indices by securities and then for the market as a whole.

We can see that today, the aggregate bubble gauge is around the 77th percentile for the overall US stock market. The circled points are in the 100th percentile and represent the bubbles of the roaring 1920s and the dot-com Bubble.

When taking a deeper dive into the readings of different stocks, is there a significant difference between them depending on their market segment? There is apparent bubble behaviour in emerging technology companies while other markets do not show any such behaviour. The stocks that are currently in a bubble are separated into baskets of “bubble stocks”. This lets us see the difference in performance since the start of 2020 for this basket compared to the top 500 companies. The market action displayed can be compared to the “Nifty Fifty” in the early 1970s and the dot-com bubble in the late 1990s.

The pandemic has left many jobless and lonely. People value freedom, and without it, we feel lost. This can explain why social media platforms gather so much more attention as we as people want to belong to something bigger than ourselves and why people are willing to trust one another. People are throwing stimulus checks and even life savings into stocks as they have historically gone up. However, this is reckless behaviour as every day it becomes more evident that we are in a bubble that is getting closer to the point of bursting. This will happen and will hurt many for years to come. The US government has implemented programs at the state and federal levels to pay unemployment grants for people to live through the pandemic and cover basic costs. These attempts, however, have led many individuals to jump into the fragile financial markets. The economy was already overheated before the initial lockdown began and has had a V-shape recovery without much sentiment behind it. Further injections of liquidity will do nothing but cause even more problems. The economy needs to reopen so that consumption can go up again. Otherwise, we might be staring down an imminent depression.


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