The Covid-Bubble

One can debate whether the current asset bubble is likely to burst anytime soon, but one cannot deny that a bubble is starting to emerge. This statement should not be mistaken for a warning of impeding market collapse, it is not. Our clients have been 100% invested since October, heavily overweight equities, and have remained fully invested over the past 3 months. Despite the timing of this article, I currently have a particularly bullish outlook, and since October have been positioned more aggressively personally than I have in years.

Yet it is important to acknowledge the financial environment we are in. Coincidentally, it has been just over a year since we published our market warning to seek cover ahead of what we believed was an inevitable pandemic-induced correction. The financial market backdrop today could not possibly be more different. Last February we predicted that the market was about to collapse; this February we believe the market is going to continue to melt up for the foreseeable future.

Where are we now?

Let us paint a picture of where we are today relative to a year ago: The tech-heavy Nasdaq index is 43% higher than it was at its pre-pandemic peak. A lot of that is easily reconciled with companies such as Shopify having been catapulted through about 5 years’ worth of growth in the space of 12 months. Fair enough, how about small caps? The Russel 2000 Index (the aggregate of 2000 small cap US companies) is more reflective of the real economy. It is 35% higher than it was pre-pandemic. That should raise one or two eyebrows. It includes companies that have had their normal business virtually shut down for the better part of a year. Now, consider for a minute the number of Starbucks coffees you used to consume on a weekly basis, and then count how many you’ve had this year. Yet Starbucks’ share price is 30% higher than it was a year ago. MGM which derives the majority of its revenues from its resorts in Las Vegas was trading at 32 pre-pandemic, and 36 as of yesterday (off the back of horrific financial results, as the business is operating nowhere near capacity). There are even more extreme examples: Tesla, which is a “lightning rod for speculation” (to borrow a phrase from one of my favorite market commentators) is up 450% in a year. There is no point analyzing metrics, there is no measure by which Tesla can be considered 5 times more valuable than it was a year ago. Yet it is. Perhaps it would be fairer to look at the polar opposite of Tesla? One could argue that is crude oil, possibly the least popular and politically most inflammatory substance on the planet. The price of crude was 52 before the pandemic. It went negative during the crisis. It is 57 today. I think you get the picture.

What caused this Covid-Bubble?

The rally we have seen extends far beyond stocks and debt and is now flooding through commodities, property, crypto currency and virtually any other asset class one can think of. It is vital for us to be clear on the fact that this is the biggest all-encompassing asset rally of all time. And it is entirely attributable to central bank action. That may sound simplistic, and sure there are nuances to it, but they hardly matter. Some argue that markets are looking through to future economic recovery. Others say it makes sense for prices to rebound given we now know Covid will be dealt with. That hardly justifies many companies being worth more than they were before Covid despite undeniably having worse businesses now. The stark reality is 90% of economies are in worse shape (GDP, employment, debt) than they were a year ago. Between the Fed, ECB, PBC, BOE and BoJ alone more than 10 trillion dollars have been added to the system. You don’t need to look any further than that to understand what has driven this surge in prices. You could also just plot any equity index against the M2 money supply, and you’ll quickly realize what is driving price appreciation. We are in a zero-interest rate environment with millions of investors chasing yield, and trillions of dollars of excess liquidity in the system. On top of it, retail investing has exploded over the past year.

How does one generally classify a bubble?

A bubble is typically defined as rapid price escalation of an asset due to accommodative monetary conditions. It is typically formed by a surge in valuations driven by exuberant market behavior. Asset prices then massively exceed the intrinsic value implied by fundamentals. I refuse to apply each aspect of the definition of a bubble to the current situation, because it is almost uncanny how textbook the current example is. There has never been a better example of a bubble. The ‘99 dotcom bubble was fairly contained, in that it mainly affected internet startups (by all metrics the current environment is as extreme). The GFC (Global Financial Crisis) was initially caused by rapid price escalation in US property markets, due to loose monetary policy and excessive credit. Bubbles are rarely created without the presence of highly accommodative monetary policy. I think 10 trillion dollars of liquidity, 0% interest rates, and helicopter money probably just about meet the definition of “accommodative”. If you choose not to label the current environment as a bubble, then you really need to lobby for a change to the definition of a bubble. That being said, we do not believe that this trend is going to reverse in the next few months.

Do bubbles always burst?

Short answer: Yes. The million-dollar question however is WHEN. We don’t think it’s imminent, and that is important. But to answer this question properly we really need to understand WHAT causes bubbles to burst. There is quite an overlap historically in which factors contribute towards bursting a bubble. Falling demand is one. In some ways the dotcom bubble burst because investors eventually realized that 95% of dotcoms were never going to turn a profit. Suddenly there were thousands of startups and nobody left to invest in them. You could potentially also call that an increase in supply. A better example of excessive supply is 2008. The demand for property certainly didn’t fade as quickly as supply increased. The market got saturated. Of course, the supply-demand curve suddenly shifting is in itself often not enough to cause a bubble to burst. In 2008 many years of excess credit and expanding supply finally only exploded once monetary conditions changed too quickly. Specifically, the rates on certain mortgages reset at a higher rate which quickly caused contagion into other asset classes. Within a few months you had a massive oversupply of properties that there was no demand for, underpinned by debt which could no longer be serviced. The GFC that emerged from it was eventually solved through an easing of monetary policy (the very thing that can lead to market exuberance). Rates were dropped to zero, and money was printed in order to ensure that the entire financial system wouldn’t collapse. Various institutions were bailed out through TARP (The Fed’s Troubled Asset Relief Program) which was authorized for upto 700bn (only 500bn was spent in the end). At the time most people, including my peers, were horrified at the prospect of printing nearly a trillion dollars of money in order to bail out a bunch of banks so that we could save the monetary system. Well, the scary thing is very few people today seem to be batting an eyelid at the fact that we have printed about 20 times as much money fighting Covid as we did dealing with the GFC. It took the better part of a decade to undo some of the damage of the GFC, and interest rates barely ever increased again.

If you haven’t been worried about the insane amounts of money flooding the system, you probably should be. It’s the elephant in the room. Nobody knows exactly how this is going to end. And again, this isn’t a sell warning right now, in fact our clients are currently actively involved. However, at some point the only remedy for dialing back trillions of dollars of liquidity is tightening monetary policy, as well as massively tightening fiscal policy. This mess needs to be paid for by the economically active through: Increased taxes, higher retirement ages, and higher inflation (inflation erodes debt). The bad news is it is unlikely to take only 10 years to fix this time round.

When will the Covid-Bubble burst?

It is difficult to put an exact timeline on this, but it seems only logical that the party will have to end when one of 2 things happen:

1. Supply increases to an unsustainable level: Unfortunately, this is like asking how long a piece of string is. Property markets suffer from excess supply when thousands of physical properties stand empty. The Covid-Bubble has unlimited supply in the sense that it encompasses every asset class, but worse, many of these asset classes have no upside limit. If Tesla can rally 500% in a year to a share-price of 900, then why can it not rally to 2000? Or 5000? The consensus right now is about 1200, and there are some respected analysts predicting 2000. Every valuation metric for Tesla didn’t make sense at 500, so why should anything change at 1200? A more extreme example is an asset class where the most experienced experts cannot value it fundamentally at all: Bitcoin. There is no valid argument to make for valuing Bitcoin at 5000, 50,000 or 500,000. So in short, supply could increase perpetually. In my opinion an increase in supply is not what is going to burst this bubble.
2. A reversal of accommodative monetary policy: I believe this is the only thing that can, and will cause the Covid-Bubble to burst eventually. As I write this lawmakers are getting ready to unveil the next stimulus package in the US, 1.4tn (or maybe it will be 1.9tn, what’s half a trillion in the grand scheme of things, right?). Right now there is no limit to what central banks will do, however there will come a time when the focus has to shift from spending to tightening. It could be in 6 months, or it could be in 2 years. Looking at the UK it is quite clear that the emphasis has shifted from spending to increasing taxes. Once the pandemic is deemed “under control” governments will have to let economic realities sink in. Obviously, this comes with massive timing differences in various asset classes and regions. The only guarantee then (as always) is those assets that rallied the most will sell-off first, and the hardest.

It is worth circling point 2) back to the GFC for a minute. The GFC undoubtedly started due to the unravelling of the subprime crisis. There was a very localized acute increase in rates in certain vintages of subprime due to the resettable nature of those particular mortgages. When those resets hit, it was like a domino effect that could no longer be stopped. You can’t stop what is legally documented in millions of mortgages. One could argue that if these instruments had been restructured the subprime bubble could have continued for a few years. This is important, because the situation today is quite different. Central banks are sitting directly at the joystick this time – they are blatantly aware that drastically changing monetary conditions would be detrimental to the system, so they are clearly not going to hit the big red button. I think it is highly unlikely central banks are prepared to cause a market sell-off at the same time that we are still fighting this pandemic. There is probably even an argument to be made that if the market were to correct by 10% they are likely to add even more stimulus. So it all really comes down to the question of how long can that trend continue. In the meantime it really is a case of “make hay while the sun shines”. I don’t see anything significant changing in the next 2-3 months.

What does one do about this?

We should start by acknowledging the true state of the environment we’re in. It is idealistic to assume that the world is dealing with this pandemic so effectively that the global economy is flourishing, and that this is in turn being reflected in the strength of financial markets. But at the same time, it is probably a bad idea to sit on the sidelines and do nothing while every asset class on earth is rallying. Here are a few pointers from real conversations I’ve recently had with clients, peers and friends:

1. Avoid large cash balances. Interest rates are zero or negative and inflation is increasing. Cash earning nothing will erode your wealth. Central banks are signaling that they will not increase rates in response to increases in inflation (i.e. they are deviating from their primary mandate). Governments desperately need inflation as inflation is one of the few things that can erode this mountain of debt.
2. If you want to participate in markets, then only speculate with money that you can afford to lose. When valuations are at these levels it is fairly easy to suffer large losses in a short space of time. Invest in themes that ultimately have longer-term fundamental merit.
3. Diversify into real assets. Protect yourself against inflation, which is a certainty at this point (not many other things are). Property is always a good asset to hedge against inflation, provide stable returns and access leverage. Property markets have gone up in most parts of the world, but they haven’t rallied as aggressively as equity markets. If you are going to chase assets, chase those that react slower to market exuberance.
4. Be disciplined. The investment world, in particular retail, has a serious case of YOLO and FOMO right now. When every serious financial expert you know tells you that the price of GameStop WILL come crashing down, listen to them. Almost everything is rallying right now which makes it tempting to jump in head first, but even in this environment there are trades that one quite obviously needs to stay away from.
5. Don’t be afraid of debt. I am not referring to credit card debt here – I am referring to cheap debt, underpinned by tangible assets. Governments and the biggest corporations on the planet are benefitting from low interest rates; you should be aligned with them. If you can borrow at 1% to invest in stable assets that generate 5%, you should be doing it. While money printing is guaranteed to stop at some point, low interest rates will be here for years, if not decades. If inflation erodes the value of government debt, it will do the same to the value of your debt.
6. Get comfortable with the fact that taxes are going to increase in most parts of the world and put more effort into being efficient in that regard. Taxes are one of the few tools that governments have  at their disposal to deal with this mess. Spend time on setting up the right vehicles for your assets and revenue streams. Be smart about maximising the benefits of your SIPPs and ISAs.

This is an exciting time to be an investor, but it is also one of the most challenging market environments we have ever seen. If you have any questions or would like to enquire about more tailored advice please contact us via the website.