While the bull market that began in 2009 has looked wobbly from time to time over the years, it has managed to recover time and again. Even the Covid-19 pandemic could not reverse the market's seemingly inexorable climb. Not everyone is so confident, however.
As market indicators increasingly flash danger signals, a number of analysts and investment professionals have become increasingly concerned. Now, with investor margin debt hitting new levels, some have begun to warn of a growing systemic threat to the market.
From bull market to bubble market
When does a bull market become a bubble market? That depends on who you ask. According to Jeremy Grantham (Trades, Portfolio) of GMO Capital, a respected value investor, we crossed the line earlier this year:
"The long, long bull market since 2009 has finally matured into a fully fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behaviour, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea Bubble, 1929, and 2000."
Judging by a number of popular valuation metrics, Grantham would appear to be right. The Shiller Index, for example, which tracks the ratio of U.S. stock prices to 10-year inflation-adjusted rolling corporate earnings, crossed the 37 mark this month, a level not seen since the height of the dotcom bubble – an ominous sign for long-term investors. The Buffett ratio, too, has continued to test record highs for more than a year, suggesting that market prices have gotten far out ahead of real economic growth.
Lately, another indicator has begun to flash red: investor leverage. Specifically, U.S. margin debt hit a record $822 billion last month, with no sign of stopping.
From idiosyncratic risk to systemic risk
Margin debt can help juice up investors' returns when things are going well, but it also magnifies losses when things go into reverse. The danger of leverage was demonstrated in spectacular fashion when Archegos Capital collapsed earlier this year, as I have discussed previously. Leverage is a dangerous tool, even in the hands of experienced professionals. Rising margin debt among retail investors may thus be cause for concern, as The Financial Times pointed out on April 22:
"The combination of investor euphoria, leverage and lofty prices has proven a toxic mix many times in the past, from Newton's South Sea bubble to more modern stock market debacles."
When market frenzy meets greed-fueled margin expansion, it can get dangerous for investors. Given how far capital markets have run ahead of the real economy, the idiosyncratic blowups such as Archegos may not be so idiosyncratic anymore. As Steven Major of HSBC Holdings PLC (HSBC) discussed in a bond market report published this month, widespread leverage may have created systemic risk:
"For all the best laid plans there are shocks we fail to forecast and feedback loops that we cannot fully understand until after they happen. When leverage is the underlying explanation behind what appears to be a series of individual episodes in financial markets — the latest being Archegos — the narrative will probably evolve from idiosyncratic to systemic risks."
My take
The continued market euphoria is concerning. While investors may be willing to keep bidding up stock prices for the foreseeable future, I fear that a market driven by ever-expanding valuation multiples will not be sustainable forever.
The long bull market has proven itself to be far more resilient than even some of its cheerleaders could have hoped. But no bull run lasts forever. As margin debt rises, the potential fallout will only get worse.
Trade carefully!
Disclosure: No positions.
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