Is the Stock Market a Bubble Ready to Burst? Here’s What Experts Say

Sentiment, liquidity, rates, and valuations — a deep dive into the current market and its future

9 min readMar 5, 2024

Is the Stock Market Headed for a Bubble? Experts Weigh In

Market conversations often revolve around the possibility of a bubble. This article dives into the question of whether the current market trend will continue its upward trajectory, independent of valuation metrics.

Instead of focusing on traditional indicators like affordability or company fundamentals, the analysis delves into individual and collective investor behavior, which ultimately drives market movements.

Investor Sentiment: Bullish, But Not Bubbling?

Market sentiment currently leans towards bullishness, but not at the extreme levels witnessed during previous bubbles. A key indicator is the American Association of Individual Investors (AAII) Sentiment Survey, which gauges investor sentiment through weekly polls on their outlook (bullish, bearish, or neutral).

Historical data reveals that the highest bearish sentiment (greater percentage of bears than bulls) coincided with the S&P 500’s bottom in March 2009, following the Global Financial Crisis. While not a foolproof indicator for market tops, the current AAII survey data suggests a bullish majority, without necessarily signaling a bubble.

Market Surprises and Strategic Shifts: Goldman Sachs Revises S&P 500 Target

The unexpected economic strength in the US and the absence of a predicted recession in 2023 have forced leading strategists, particularly those from influential sell-side firms, to reassess their market forecasts.

This trend is exemplified by Goldman Sachs’ equity strategy team, who initially projected the S&P 500 to reach 5,100 by December 31st, 2023. However, due to market outperformance, the team has already revised their target upwards to 5,200.

Market Psychology and Strategic Shifts: Bulls Charge, Bears Capitulate

Current market sentiment is characterized by upward revisions in forecasts from prominent strategists like Savita Subramanian (Bank of America) and Nouriel Roubini, despite initial reservations. Subramanian, while acknowledging the potential for a “neutral” call due to already strong market positioning, increased her year-end target from 5,000 to 5,400, citing “improving sentiment across Wall Street.” This sentiment shift is further bolstered by the unexpected capitulation of prominent bears like Roubini, who has recently expressed optimism about a potential “no-landing” scenario for the US economy.

Market Liquidity and Bubble Formation: A Delicate Balance

Market bubbles, whether in physical assets or financial markets, are often fueled by abundant liquidity. Increased access to cash can lead investors to seek out investment opportunities, potentially driving up asset prices like stocks.

Mike Howell, an analyst at CrossBorder Capital, utilizes a specific metric: market capitalization divided by liquidity. This ratio reflects the susceptibility of stocks to price increases based on available liquidity.

While increased liquidity can initially support market growth, a rising ratio becomes a cause for concern. It suggests that an increasing proportion of available money is flowing into stocks, potentially signaling the late stages of a bubble.

Current market conditions:

The global liquidity landscape currently benefits the S&P 500, mitigating concerns about solely US-driven market growth.
The long-term correlation between the S&P 500 and Howell’s global liquidity measure emphasizes the importance of monitoring liquidity levels to identify potential bubble formation.

US Outperformance: The Dollar’s Role and China’s Challenges

The outperformance of the US economy compared to the rest of the world since the Global Financial Crisis (GFC) can be partially attributed to shifts in global currency flows.

Key factors:

Net inflows to the US dollar: Data analysis reveals a significant increase in net dollar inflows from foreign investors since the turn of the century. This shift from previous outflows contributed to US economic strength.
China’s economic challenges: Growing concerns surrounding the sustainability of the Chinese economic model are believed to be a key driver of these dollar inflows, as investors potentially seek a perceived safe haven in the US.

Additional considerations:

This analysis highlights the interconnectedness of global economies and the impact of currency flows on national performance.
While the dollar’s strength has benefited the US, it can also present challenges for American exporters.

US Stocks: Extended or Under Global Liquidity Umbrella?

Mike Howell, an analyst at CrossBorder Capital, analyzes the valuation of the S&P 500 through the lens of both domestic and global liquidity.

Key findings:

Domestically: The S&P 500 appears extended when considering solely US-based liquidity flows.
Globally: The picture changes significantly when incorporating global liquidity as the benchmark. In this scenario, the S&P 500 appears less stretched, suggesting potential for further growth.

Howell’s hypothesis:

Continued dominance of US tech and AI companies fuels the possibility of the US stock market becoming the “World market” for these sectors, justifying higher valuations under the umbrella of global liquidity.

Market Calm and Bubble Potential: The Macroeconomic Perspective

Current market conditions characterized by stability may be conducive to bubble formation, as suggested by economist Hyman Minsky’s theory.

Key factors:

Fathom Risk-Off Gauge (FROG): This indicator, developed by Fathom Consulting, analyzes macroeconomic trends, market liquidity, and the relationship between bonds and stocks to determine the probability of a risk-off environment (where investors favor bonds over equities).
Current FROG reading: The current FROG reading suggests a low probability of a risk-off scenario, potentially supporting continued market stability and upward momentum.

However, it’s crucial to remember:

Market calm doesn’t guarantee future stability.
Minsky’s theory emphasizes that prolonged periods of stability can create conditions ripe for disruption.

Therefore, remaining vigilant and monitoring market indicators like FROG remains essential for identifying potential risks and making informed investment decisions.

Interest Rates and Stock Market Performance: A Delicate Dance

Historically, interest rate cuts have often been associated with increased market activity and potential for speculation. With several rate cuts anticipated before the end of the year, the key question becomes: will these cuts be justified?

James Reilly of Capital Economics provides a crucial insight through his chart analysis, which reveals the following:

Rate cuts followed by economic expansion: In these scenarios, stock markets typically experience upward trends within the next year.
Rate cuts followed by recession: Such situations often see stock markets unable to avoid losses despite the rate cuts.

This highlights the critical relationship between the justification for rate cuts and their impact on the stock market. While rate cuts themselves may not directly trigger bubbles, they can create an environment conducive to speculation if not accompanied by appropriate economic conditions.

Therefore, it becomes vital to:

Monitor the economic rationale behind rate cuts.
Acknowledge that historical trends do not guarantee future outcomes.
Utilize this information alongside other market indicators for informed investment decisions.

Interest Rates and the Stock Market: A Nuanced Relationship

The potential impact of interest rate cuts on the stock market remains a topic of debate, particularly in the context of a slowing economy. While historical examples exist where rate cuts have coincided with market growth (e.g., post-1998 Russian default), the current scenario presents unique considerations.

Key insights:

James Reilly of Capital Economics argues that rate cuts alone might not be sufficient to inflate a bubble further, given the potential for falling equity risk premiums due to hype around AI.
This market rally’s resilience even with rising bond yields strengthens this argument.
Ed Cole of Man Group proposes that the Federal Reserve’s shift in its reaction function towards a more symmetrical approach (less focused solely on lowering inflation) has been a key driver of the recent market surge. This is interpreted as a sign of the Fed’s increased support for the market, potentially even tolerating a bubble.
Supporting this viewpoint, financial conditions have already eased significantly despite growing expectations of future rate hikes (as evidenced by Bloomberg’s financial conditions index).

However, it’s crucial to remember:

Historical correlations don’t guarantee future outcomes.
The complex interplay between economic factors, central bank policies, and market sentiment requires a nuanced analysis.

Federal Reserve Policy and Stock Market Performance: A Look at History

Despite the recent market rally, history suggests the Federal Reserve (Fed) may not be deterred from cutting rates due to a strong stock market.

Key takeaway:

An analysis by Citigroup reveals that the majority of past rate-cutting cycles by the Fed began with the S&P 500 trading above its 200-day moving average, indicating a bullish market.

Nuance:

While the Fed may cut rates by a smaller magnitude when the market starts strong, the likelihood of rate cuts itself isn’t necessarily diminished. This suggests the Fed prioritizes economic factors over short-term market fluctuations when making policy decisions.

Implications:

Investors should consider a broader range of economic indicators beyond just the stock market performance when anticipating Fed policy changes.
Historical trends, while informative, don’t guarantee future outcomes.

IPO Activity and Valuation: Gauging Market Exuberance and Long-Term Risk

The Initial Public Offering (IPO) market can offer valuable insights into irrational exuberance within the stock market. While newly listed companies often underperform in their initial years, investor enthusiasm can reach excessive levels during bubbles.

Nicholas Colas of DataTrek International proposes that first-day IPO gains serve as a useful indicator of bubble-like sentiment.

1999 Dot-com Bubble: This period saw a record number of IPOs (476) with an average first-day gain of 71%, highlighting extreme investor fervor.
Post-Pandemic Market (2020–2021): While not reaching the same extremes as 1999, average first-day gains remained elevated at 42% and 32%, respectively.
2023: The year witnessed a significant decrease in IPO activity (54) and a lower average first-day gain (12%), suggesting a shift towards focusing on established quality companies, even at potentially premium valuations.

Long-Term Perspective:

While short-term market predictions are often challenging, valuation metrics become increasingly important when considering long-term investment horizons.

Savita Subramanian’s analysis: Her recent target revision for 2023 included a chart demonstrating a strong correlation (over 80%) between price-to-earnings (P/E) ratios and subsequent 10-year stock market returns.

Key takeaways:

Excessive first-day IPO gains can signal potential market bubbles.
Valuation metrics like P/E ratios hold greater significance for long-term investment strategies.
A balanced approach, considering both short-term sentiment and long-term fundamentals, is crucial for informed investment decisions.

Market Boom and Bust: A Look at the Long Game

While the current market rally appears promising, a cautionary approach is necessary. Here’s why:

Potential for a Decline: Historical trends and current valuations suggest that the next decade might hold challenges for the stock market.
Short-Term vs. Long-Term: While share prices may continue to rise in the near future, it’s crucial to anticipate a potential downturn following the peak of this rally or bubble.

Investor Considerations:

Bubble Psychology: The allure of a growing market can be tempting. However, investors should be prepared to exit their positions strategically when the bubble bursts.
Long-Term Planning: Valuation metrics and historical data become increasingly important for navigating the potential volatility of the next 10 years.