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Are we in a stock market bubble?

2020 was a tumultuous time for the world, with Covid-19 causing a global pandemic. However, whilst economies are suffering in the wake of this, the stock market seems to keep rising to newer and better heights each week. The disconnect between the economy and the stock market may prove to be a worrying sign. Could we be in the middle of a tech-led stock market bubble that is set to burst at any point? Or is this just the start of another bull run which will see stocks continue to increase in value?



What is a bubble?


A stock market bubble is like a normal bubble; both require certain conditions in order to be created and to expand. The first is a rapid increase in prices that forces valuations near or even above their historical highs. Second is an increase in speculative behaviour from investors. These two conditions create a stock market bubble, and, like any bubble, it grows bigger and bigger until it bursts, which, for the stock market, results in a big crash.


At the moment, many stock prices, particularly within the tech industry, are far above what the company is actually considered worth. This is mainly driven by speculation from investors rather than improved fundamentals. The extreme overvaluation of many companies, created by high speculation in the markets, suggests that many investors have lost touch with reality and could prove very costly to them.


Tesla


A great example of these current inflated stock prices is Tesla. When we took a look at Tesla back in July, we also believed it was overvalued and no one expected it to reach the heights it has today. It just goes to show that an overvalued stock can easily continue to grow, so although Tesla’s valuation is even crazier today, we could definitely see it go even higher. Who knows when the bubble will burst?


Tesla has seen immense growth since the pandemic started in March, and has recently made Elon Musk the richest man in the world. Tesla’s stock price has risen over 1000 per cent from a low of $72.24 per share in March to $844.90 per share today. Now, the question that most investors want answered: is the stock overvalued? The simple answer is yes, it is.


From just looking at some of Tesla’s financials, you do not have to be an expert to see that its crazy valuation is not backed by strong fundamentals. Let's first look at Tesla’s price-to-earnings (P/E) ratio, which is the ratio of a company’s share price to the company’s earnings per share. The P/E ratio is a great indicator of whether or not a company is overvalued, and a high P/E ratio would suggest an overvaluation. Tesla is definitely on the higher end of the P/E ratio scale with a value of 1700.56 today. This compares to the industry average of around 15, which is quite extraordinary, and when compared to our report on Tesla in July, the P/E ratio was at 450x. So, how has Tesla’s P/E ratio been able to rise so high?



Tesla PE ratio. Credit: Ycharts

A company’s P/E ratio is calculated by dividing the share price by the earnings per share. As such, Tesla’s high P/E ratio is as a result of a large difference between these two metrics. Tesla’s market capitalisation is approximately $802 billion, which is far above the industry average, but has an earnings per share of $0.497 which is more in line with the industry average, so its large market cap is what is causing the high P/E ratio.


Tesla’s market cap has many investors searching for answers. This is because, among its competitors, Tesla actually sells far less cars, but somehow has a far greater market cap. BMW, whose market cap is $45.98 billion, sold 675,680 cars in Q3 2020, compared to Tesla’s 139,300. So you may be wondering how Tesla can be valued so high even though they sell less than their competitors.


Tesla was able to continuously beat earnings expectations this year which gave investors a great reason to keep on investing. The company looks healthy and stable, but extreme speculation in the markets at the moment to almost hysterical levels is what has really caused the Tesla rally. Although, Tesla was able to beat earnings expectations this yea,r they still have a revenue which is very small compared to their market cap and speculation in the economy has created several companies like this.


This boom in speculation has been aided by a rapid increase in retail trading this year. Retail trading has increased immensely during the pandemic, especially within options market. In Q3 2020, the Nasdaq’s U.S. options market reached a quarterly record of 660 million contracts traded, which is a 52 per cent increase year-over-year. This is mainly driven by young people who are starting to age into money and want to manage this money for themselves. This, when added to the volatility of the market and the high speculation, created a perfect storm for companies like Tesla to soar in value to dangerously high levels with little fundamental support, making the stock market bubble grow bigger and bigger.


Are we in a bubble?


The interesting thing about price bubbles is that they cannot be identified whilst they still exist; only once a bubble has popped can we state that there was indeed a bubble. Only in hindsight can we say for sure that we were in a bubble, but there are several signs which suggest that we could well be in one now.


The two fundamental properties of a bubble are stocks reaching new highs and increased speculative behaviour - we definitely have both of here. History has shown that when a stock market is seen as overvalued, it more often than not corrects itself with a big crash.

If we look at the cyclically adjusted price to earnings ratio (CAPE) which gives a slightly more accurate version of the P/E ratio by adjusting it for inflation, we can see some worrying signs in the U.S. stock market.



The graph above shows the CAPE for the S&P 500 for the last 100 years. When the CAPE ratio increases, it suggests that the stock market is overvalued. For the large majority of history, the S&P 500 CAPE has been quite steady and only a couple times has it shown high valuation. This was before the 1929 market crash which started the Great Depression and in the late 1990s during the Dot Com bubble which saw one of the largest market crashes in history. Now, the CAPE ratio for the S&P 500 is above what it was in 1929 and is climbing towards the crazy highs of the 1990s. This at first glance can look very concerning, and it is in some respects, but it does not show the full story.


Whilst stock markets have steadily risen over the years, interest rates have fallen quite considerably. This has very important implications for valuation. Interest rates are linked with investment value - when interest rates are low, this makes investments in stock markets more attractive and more valuable. This is because investors do not want a 1 per cent return on their money; they want 10 per cent, 20 per cent, or even higher returns on their money, and the stock market, although a lot riskier, offers this potential.



This graph shows the 10-year U.S. Treasury yield, and, as you can see, we are at the lowest point in history. So when we look at this it is not surprising that investors are flocking into the stock market with little to no knowledge of what they are investing in. Stocks are not necessarily more expensive just because ratios like CAPE and P/E have increased, they are just more valuable because they provide a better alternative to interest rates. Low interest rates do provide sound reasoning behind why, in part, many stocks have such high valuations. But, these stocks are still far above what they should be, and this is a very risky and dangerous situation that stock markets are currently in.


Concluding remarks


Low interest rates coupled with extreme volatility in the markets over the past year has sent retail investors into a frenzy over stocks like Tesla, which has led to many crazy valuations in the market at the moment. I think it is safe to say we are in a stock market bubble with stocks being more expensive than ever and traders being more and more speculative. However, I cannot say when this bubble may burst; we could be at the start or the pop could be right around the corner. Either way, with high uncertainty in the markets right now, diversifying your portfolio to reduce risk exposure is a good idea.

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