A Review Of Stock Market Valuations - Part 2

The traded options market is also an important indicator of risk. When the stock market falls, price volatility tends to rise, but option prices can anticipate changes in risk appetite. Without delving too deeply into the dark arts of options trading, in stable market conditions, call options tend to have lower prices (and therefore lower implied volatility) than put options, since investors tend to sell call options against their underlying portfolios but purchase put options to protect themselves from sudden market declines. There is a lot more to option pricing and trading than we can discuss here, suffice to say the Chicago Board Options Exchange (CBOE) calculates a SKEW Index – the difference between the relative price of different call and put options. SKEW values generally range between 100 and 150 - the higher the value, the higher the perceived tail risk. A reading of 100 should represent its lower bound (low tail-risk). For a further explanation, I defer to David Kotok of Cumberland Advisors - GameStop And SKEW: -

Source: CBOE, Cumberland Advisors

When you examine the SKEW methodology closely, you realize that a 79.25 price is practically impossible. It would mean that the stock market is paying you to take a tail-risk. In other words, such a price means that a trade can be constructed in which the investor cannot lose significantly. This is never supposed to happen. But we see that there is evidence that such a trade may have occurred on the same day as the wild swings of short covering and GameStop trading. That price suggests a market distortion that was quickly multiplied by many times.

Markets are complex systems, the price action in GameStop – and other small-cap securities - feeds through to the options market, which in turn impacts other markets. The hedge fund Melvin Capital survived the brutal GameStop short-squeeze to fight another day but the episode is reminiscent, in a more contained way, of the LTCM debacle of 1998 – here is the report of the President’s Working Group on Financial Markets from April 1999 - Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management.

The Robinhood Effect – a lethal mixture of work from home, stay at home, and getting a government relief cheque – has been mirrored among other online brokers: -

Source: Horizon Fintex

A similar rise in first-time retail customers is evident in the Cryptocurrency and Foreign Exchange markets.

Another sign of assets being in bubble territory is the performance of the housing market. Now, it goes without saying, all property is local, but looking at the US, where the fiscal and monetary response has been the largest, we find yet another asset market at an all-time high: -

Source: Federal Reserve

The rise in house prices has been fuelled by cheap money: -

Source: III Capital Management, Bloomberg, JP Morgan

Combined with a shortage of supply: -

Source: III Capital Management, Goldman Sachs, NAR

Finally, fiscal and monetary expansion is akin to fiat currencies have debasement, it is a scant surprise, therefore, to see Cryptocurrencies resurgent. The chart below shows the combined market capitalization of all the listed digital currencies: -

Source: Coinmarketcap.com

Of course, the principal focus of the media has been on Bitcoin (BTC) access to which was made available to Paypal customers from October 2020. This month’s big stories include Telsa (TSLA) purchasing $1.5bln of BTC during January and Mastercard indicating that they intend to accept BTC as a form of payment later this year. The next chart shows the rising dominance of BTC (61%) compared to the previous peak in 2017: -

Source: Coinmarketcap.com

Ethereum (ETH) is second with a mere 12.7%. Putting digital assets in perspective, however, the market capitalization of BTC, which just topped $1trln last week, is still less than 10% of the total market capitalization of gold.

Whether or not one regards digital assets as an alternative store of value, soon to displace what Keynes dubbed the barbarous relic (gold), it is incontrovertible that the digital asset industry is in its infancy whilst the underlying technologies - DL, Blockchain, and DeFi - have the potential to disrupt the entire financial system - who needs banks or other financial intermediaries in this brave new decentralized world? Coinbase, which has been described as the Robinhood of the Crypto world, is planning an IPO for later this year. The current indication is that it will achieve a capitalization of $77bln.

What is of concern is that the Crypto charts above wreak euphoria. Traders and investors with no prior experience, have jumped on the trend and now command cult-like status among the ingénue. Some of their followers will be lucky, but these price patterns are the tell-tale traits of a greater fool’s marketplace.

Even in the liquid, large-cap names, echoes of the DotCom bubble are apparent. Apple (AAPL) and Tesla (TSLA) stock rose more than 50% in the days after they announced stock splits. Apple created more value for shareholders by announcing a stock split in 2020 than through its new product launches, Tesla, which declared the first profit in its 18-year existence in 2020 ($721mln) has made more from its purchase of Bitcoin than it has made in its lifetime.

In a recent post, on what many have dubbed the everything bubble, - Is This The Biggest Financial Bubble Ever? Hell Yes It Is - John Rubino concludes: -

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