One of the tricky things about asset bubbles is that they
cannot be conclusively identified while they still
exist.
Only once a bubble has popped can we be sure
that it was ever there at all.
There are, however, two necessary if not sufficient
conditions for the existence of a bubble.
The first is an accelerating increase in prices
that forces valuations near historical highs.
The second is increasingly speculative and insane
behaviour among investors.
In the US stock market we clearly
have that first box ticked.
Here is the Nasdaq index, which is heavily
weighted towards technology, the sector where valuations
have been the frothiest.
It has risen 40 per cent this year
despite the small matter of a global pandemic
and an accompanying weak economy.
Crazy behaviour?
There's plenty of that going around, too.
Perhaps the ripest example of investor insanity
is a barely profitable electric car
company that has seen its share price octuple this year.
Here is a chart of Tesla shares.
There was a two-day period a couple of weeks
ago in which Tesla added the entire market value of the Ford
Motor Company twice over.
Or how about the rocketing price of an asset
that, depending who you talk to, may have
no underlying value at all?
The cryptocurrency Bitcoin.
Now, the argument that there is not
a bubble in the American stock market
is that stocks have to be so expensive because government
bond yields are so low.
That is to say while stock prices are high,
the premium that investors receive
for owning stocks as opposed to bonds
is actually at the low end of the historical range.
Here is a chart of the 10-year inflation
adjusted or real yield.
The great investor Jeremy Grantham
says that justifying the high prices of stocks
by pointing to historically low bond yields
is nothing more than justifying one asset bubble by reference
to another.
He may have a point.
But the fact remains that the Federal Reserve
can keep bond yields low simply by buying
more and more Treasuries, that is,
unless inflation spikes and the situation
gets out of the Fed's control.
The question of whether we have an asset bubble in the US stock
market is nothing more or less than the question
of whether we have been too complacent
about the possibility of inflation.
If you own stocks, keep a close eye on the prices of everything
else.