Some things never change. As stock prices surge, investors convince themselves that this time will be different. The last bubble might have popped, but the current one is thought to last.
In Canada, we famously saw this with cannabis, where retail money rushed into a sector that hadn’t yet been legalized – only to get burned. We’re seeing it again today in tech. And biotech. And anything related to virtual health care.
Long before GameStop Corp. captured the general public’s attention, these sectors – and a few others – had turned frothy, which meant their share sales were selling into heavy demand, and companies that have never made money were being rewarded with rich valuations.
The themes underpinning this rally are credible ones: Interest rates are so low that equity returns look much more attractive than bond yields; the pandemic has accelerated a shift into e-commerce and the digitization of many sectors – including family medicine; and COVID-19 vaccines are rolling out, so the light at the end of the tunnel is visible.
But we’re at the point where the rally starts to feel invincible. The Nasdaq Composite Index is up 33 per cent over its prepandemic record, yet the U.S. unemployment is still close to double its low before COVID-19 erupted. It’s around now that fears of being in bubble territory start to creep in.
This does not mean we are at the top. The current rally could still have legs, especially because the past week has awakened scores of retail investors who may not have been paying much attention before.
Yet the undeniable truth about bubbles is that they always pop. Remembering that is important because a rally can collapse quickly – and with force. It’s never quite clear what will do them in, but based on previous bubbles, and on current market dynamics, here are six things to watch out for:
Both the U.S. Federal Reserve and the Bank of Canada have pledged to keep their benchmark interest rate near-zero until 2023, but there is already chatter that the Fed might have to hike sooner than that. Recent economic indicators, such as retail sales, have shown that consumers on both sides of the border are readily willing to spend again, and they are sitting on cash.
President Joe Biden is also hoping to pass another large stimulus bill, and there is a chance it could reheat the U.S. economy very quickly. Even if the Fed remains committed to its low rates, the mere expectation of hikes can send bond yields soaring, which matters because low yields have been a major driver of the rush into stocks.
The smart money cashes out
Historically, retail investors have been at a major disadvantage to institutional investors, who tend to have a better pulse on intraday trading (GameStop notwithstanding). When these institutions decide to cash in their profits, it can turn the market. Profit-taking, as it is known, can fuel more profit-taking, and by the time it reaches the average investor, there can be such a scramble to get out that it fuels panic selling.
Hitting an air pocket
During a feverish rally, very few investors challenge the market orthodoxy. It can even become cult-like. But there have been times where a rally flies into an air pocket – which is what happened to energy stocks in the fall of 2014. So much money piled into the sector because there seemed to be never-ending demand for oil, but something clicked in September, 2014: Investors realized the rally had funded oil supply increases, and now the world would be awash in crude. Many energy companies never recovered from that price crash.
If a bubble grows too big, it can become a risk to the broader financial system, which is why regulators – and even financial institutions – worry about something called market integrity.
It could be that a sector gets too frothy, prompting some blue chip investors to retreat. That has the power to not only push the market lower, but also starves it of stable, longer-term capital.
Or it’s possible too many retail investors trade on margin, meaning they borrow money for cheap from a platform such as Robinhood, and then invest it. When a market swings wildly, it can force a regulator to step in and curb trading, to make sure the trading platform has enough of a cash cushion to cover potential loan losses.
Even if such speed bumps are temporary, they can take air out of the rally, and that can freak investors out.
Evolving economic expectations
Investors seem certain that vaccinations will end the pandemic in the West by fall, and that a digital economy is the future. What if the vaccine rollout takes longer than expected? Or worse, that new variants emerge and we have to wait for new booster shots? We also don’t know yet how much our lives will snap back to prepandemic norms, particularly for activities such as retail shopping.
Time, plain and simple
During the recent cannabis rally, you could scream bubble until you were blue in the face yet retail investors – and even some corporations – did not care to listen. What finally changed the narrative was a few quarters of ugly profits after recreational cannabis had been legalized. All the hopes of a massive market for new marijuana smokers vanished, and the market spiralled downward from there.
It was an important reminder: Sometimes, waiting for a correction requires patience. Markets can only defy gravity for so long. But you also can’t assume investors will be rational. The housing market, for one, was expected to crash years ago – and it’s now hotter than ever.
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