Yes, Virginia. There Is A Stock Market Bubble

"Yes, Virginia. There is a stock market bubble. "

In 1897, an 8-year girl named Virginia O’Hanlon sent a letter to the New York Sun questioning Santa Claus’s existence. Why? Because her friends had all told her that Santa Claus didn’t exist.

As we enter 2021, there are two myths told to investors to support the bull market narrative. The first, as we debunked recently, is that low-interest rates justify high valuations. The second is that since valuations are not as high as the “dot.com” crisis, there is no “stock market bubble.”

Both of these views are rationalizations by investors to continue overpaying for assets during a liquidity-fueled bull market. Unfortunately, as investors pile further into risk assets, driven by herd mentality and confirmation bias, the eventual outcomes have been less than kind.

“My confidence is rising quite rapidly that this is, in fact, becoming the fourth ‘real McCoy’ bubble of my investment career. The great bubbles can go on a long time and inflict a lot of pain, but at least I think we know now that we’re in one.” – Jeremy Grantham

That was a comment he made during a CNBC interview when discussing the market’s rapid rise following the March correction. 

What Is A Bubble?

What is the definition of a bubble?  According to Investopedia:

“A bubble is a market cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. Typically, what creates a bubble is a surge in asset prices driven by exuberant market behavior. During a bubble, assets typically trade at a price, or within a price range, that greatly exceeds the asset’s intrinsic value (the price does not align with the fundamentals of the asset).

While this definition is suitable for our discussion, there are three components of a “bubble.” The first two, price and valuation, are often discussed and readily dismissed during the inflation phase.

Jeremy Grantham recently produced the following chart of 40-years of price bubbles in the markets. During the inflation phase, each was readily dismissed under the guise “this time is different.” 

Stock Market Bubble, Yes, Virginia. There Is A Stock Market Bubble.

Valuations are also quickly dismissed with “new metrics,” like Shiller’s recent endeavor into “earnings yield.” 

Stock Market Bubble, Yes, Virginia. There Is A Stock Market Bubble.

But what we do know is that valuations have a massive impact on expected returns.

Here is “the thing.”

“Market bubbles have NOTHING to do with price or valuations.”

The Rudimentary Theory Of Bubbles

Let me explain.

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