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This time, it’s different7 min read

By Nicolaus Schmandt

The image for this article shows the cycle of human emotions as the stock market goes through booms and busts. Investors should never forget it, especially as we are moving towards the “euphoria” peak, with speculative bubbles growing in tandem. Each time this happens, the bubble comes with a narrative as to why stocks should be so much above normal valuations, or why the rules don’t matter anymore. In the years leading to 2008, everyone was moving to the sunbelt and their properties and mortgages would never go down in value. In 1999, the internet was going to fundamentally change the world in such a way that normal valuations simply wouldn’t apply. In the 1800s, railroads were going to change the fundamental values of goods and commodities.

What’s the narrative this time? That low interest rates will make equities go up forever. If you’d made the connection between low rates and higher equities in 2008, you would have made a fortune. But while low rates might sustain a market rise over several years, they cannot sustain Tesla’s 1000% gains. And while liquidity does help equities, you can’t just borrow from the Fed and buy stocks of money-losing companies. In other words, in the end it’s going to follow the same cycle as all the previous bubbles. And the most similar equity bubble, the dot-com bubble of the 1990s, is now far enough behind us that many have forgotten its lessons, or are too young to have really experienced it. The cycle pictured for this article is probably partly driven by crops of investors who have yet to experience different parts of the cycle.

Besides the record low interest rates, another difference is the number of people participating in the markets. It’s never been so easy to be trading stocks and options live from the comfort of your own home, especially when there’s nothing better to do. The unprecedented nature of these times also empowers individual investors: COVID and the federal reserve’s massive market moves were so unprecedented that there was no historical precedent, and established institutional investors’ guess about what was coming next were just as good as anybody else’s. Everyone was trading off the same headlines.

Such a large number of people trading options is also new. But this does have a historical precedent: “bucket shops” of the early 1900s. If you haven’t heard of them before, they were places where people could gamble on stock prices without actually owning any stocks. People would bet on stock prices, and with much larger margins than a regular brokerage account would allow, but they would lose it all if the stock exceeded certain bounds over a certain period of time, very similar to the nature of options trading today. As the bucket shops got bigger, agencies running them would manipulate markets to push stocks to trigger the margin loss for the players. The brokerages selling options will probably do the same thing, if they aren’t already. Bucket shops were ultimately made illegal after they were believed to have significantly increased the severity of market crashes. Options trading may meet the same fate.

But as we are driving towards another “euphoria” peak, figuring out exactly where we are and when the end will come is the tricky part. There’s plenty of evidence to suggest that we are getting close to the peak, but the market may still have room to run. Though stocks are breaking record highs in valuations, bonds are breaking record lows in yields. The spread between stock dividends and bond yields is still quite high, simply because the bonds are so low. And bonds, at least safe ones, are well past negative real interest rates, which means they have nowhere to go but down, and investors chasing yield may have no alternative to equities.

In short, it’s a tricky situation, because there is still good value in stocks, but considerable risk. You don’t want to be holding a big portfolio when the herd finally does get spooked and start rushing towards the exit. And what could spook the herd? No one knows for sure, but so far COVID and the market selloff that came with it, bad earnings reports and economic readings, and even a few stock favorites either collapsing or getting exposed for fraud (Nikola, in particular) have failed to crash the party. Whatever does bring the end will have to disrupt the ongoing narrative, that low interest rates will drive stocks up indefinitely.

Here’s my short list of what could potentially end the run:

1) China – Might be weird to see a country that’s been touted as a COVID success story at the top of the worry list, but the truth is none of China’s economic numbers can be trusted (see also this article). And they have been closing the windows of transparency to the outside world, meaning we are losing our window of insight into the country. This is not limited to the public sector: we’ve recently seen massive fraud cases for publicly-traded Chinese companies, brought down by only simple analyses by short sellers. The real story in these fraud cases is how far they got and for how long they got away with it. Other worrying signs include increasing levels of default and an uptick in failing banks, in addition to an ever-growing property market bubble. All of this means China could fall into a very deep economic hole and we may not even know it until it is too late. A soft landing is unlikely.

2) Bad economic data…but after COVID – Everyone is expecting and has priced in a quick and immediate recovery from the virus. Bad economic data before the recovery is meaningless. But if, even after the virus, the recovery is weak and we start to see major economies falling back into recessions in the post-COVID world, this could trigger a major rethinking of the economic outlook. A market selloff of equities would likely follow, and compound the damage of any recession.

3) A change of course from the Federal Reserve – The Fed has used falling prices in consumer goods as a reason for keeping interest rates low for a long time now. The problem here is these goods are getting increasingly automated, meaning they are detached from the rest of the economy and labor market. The main input to produce these goods is becoming electricity, and very little labor. It’s going to be difficult to get their prices to rise by lowering interest rates, as much as the Fed seems determined to try. And unfortunately there is still plenty of room for these products to increase productivity further, creating downward pressure on prices for the foreseeable future.

Other elements of the economy, such as asset value and the price of services, are already seeing significant inflation, driven by the low interest rates. The Fed may need to consider more seriously the unwanted side effects of low interest rates, especially asset price inflation and the destruction of returns for pensions and savings accounts. It’s like the Fed is elbowing aside normal lenders in a rush to give banks money, well past the point of diminishing returns. If nothing else, it is causing investors to chase more speculative gains for growth in their portfolios, instead of normal investing returns.

Regardless, if they do rethink their strategy with rates, or something else happens to cause them to raise interest rates, I would expect a tremendous amount of air to be released from equities. Several companies will go bankrupt and there will certainly be a large and painful market correction.

4) Antitrust lawsuits against big tech – These likely constitute major threats to many of the highest-flying tech stocks, especially Google and Facebook, who (in my opinion) are blatantly engaged in monopolistic behavior. The market has so far shrugged these lawsuits off, perhaps because they are still years away from actually going to court. If nothing else, expect volatility when litigation does actually go forward, and if the outlook looks unfavorable for the companies, I would guess that could lead to a market collapse.

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