If the Stock Market is in a Bubble, What Will Trigger A Crash?

Photo by Jamie Street on Unsplash

Due to the lack of spending as a result of the global Pandemic and being flush with cash from the Fiscal Stimulus, some Americans are saving now more than ever before.¹ However, as interest rates are at historic lows, some of those founds have been invested into various asset classes, leading to unusual market behavior. Whether it’s purportedly Robinhood traders² or Wall Street Bets on Reddit³ or general investor euphoria⁴, various asset classes are breaking record highs.

The typical indicators of a bubble⁵ are as follows:

  • Low interest rates

It’s seeming more and more likely that there are minor bubbles across multiple asset classes such as:

1. Stocks: The CAPE Ratio⁶ and Buffett Indicator⁷ are at record highs not seen since other major financial crises such as the Great Recession, the Dot Com Bubble, or even the Great Depression. For example, the S&P500 is valued at 22x predicted earnings (the historical average being 16).⁸

2. Real Estate: Although much less speculative than the stock market, housing prices are beginning to exceed income⁹.

3. Bitcoin: Volatile price shifts rendering it obsolete as a digital currency.¹⁰

This level of mania isn’t sustainable. A huge assumption of the market rallies seems to be that the COVID vaccines will succeed and then business will resume as normal, resulting in a huge increase in consumer spending and thus huge jumps in future earnings. However, the vaccine rollout has been slow¹¹, new variants have appeared which may not be adequately dealt with by existing vaccines¹², and the domestic dysfunctionality around managing the pandemic has allowed the virus to spread far and wide. Instead of a quick resolution of the pandemic, it is more likely now that it will likely drag out for years to come¹³. Thus, as the market is confronted with the new reality of a resurgence of the virus, it is only a matter of time before these historic rallies peak and begin to go in the opposite direction.

Indicator to Watch: Inflation Rate Spike

Once we’ve identified an asset bubble, the question is, what will trigger it to pop? The most likely candidate is a dramatic increase in inflation and corresponding interest rates. Under normal market circumstances, when inflation rates surpass 2%, the Federal Reserve typically will intervene and do a rate increase.¹⁴ The current inflation rate as of December 2020 is 1.4%, up from 1.2% from October / November, 1.3% in August, and 1% in July. The lowest it was in 2020 was April (0.3%) and May (0.1%).¹⁵

If the inflation rate holds steady, it’s unlikely the Federal Reserve will increase rates. But if there’s a huge jump in inflation, the Federal Reserve is likely to respond with an interest rate hike. If that happens and it comes as a surprise, that could trigger the popping of the bubbles — although it is notoriously difficult to time the market. If that bubble pops and the markets drop, that would be the best time to buy great stocks at a bargain price.

The next inflation rate update is scheduled for February 10th, 2021.

Note: While a spike in inflation is the most likely candidate for a market turn, another possible trigger of a market decline is a financial contagion that emerges from another part of the world which then spreads to the U.S.

Sources

  1. More Americans Are Saving Than Ever Before, Though in Unequal Amounts” (Independent Tribune 2021)

Adjunct Professor at Georgetown University · CEO of Fifth Tribe | DC’s Digital Agency · Focus: Product Innovation & Digital Strategy

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