The economy is suffering as a consequence of Covid-19 and measures taken to contain it, yet share prices have been rising sharply. This raises the possibility that the stock market is now in a bubble, with valuations increasingly detached from business and economic fundamentals.
At the beginning of 2020, stock markets around the world began to fall precipitously as the scale of the Covid-19 crisis became clear. In mid-March, however, this trend suddenly reversed, and share prices began to rise. Despite the fact that many developed economies are undergoing their worst recessions in living memory, share prices in those countries have now returned to historically high levels. Why?
Figure 1. S&P 500 Index (United States), FTSE 100 Index (UK) and Shanghai Stock Exchange (SSE) Composite Index in 2020
Source: Yahoo Finance.
Note: All indices are set equal to 100 on 2 January 2020.
What moves share prices?
The value of a share is based theoretically on the future income streams to which its holder is entitled. The demand for shares is therefore assumed to be proportional to the value of these future income streams, which is in turn determined by two things: the profitability of the underlying company; and the rate of return on all other assets (which can be approximated by the economy’s interest rate).
A rise in share prices is therefore usually either a response to good news for business or a response to a fall in interest rates. These two factors are referred to as the ‘fundamentals’ of a share. Since future fundamentals are unknown, the potential for subsequent variation in profitability or interest rates must also be factored into the valuation of shares – in other words, how safe or risky they are.
Has the fall in interest rates been driving the stock market bounce?
In March 2020, central banks around the world used a series of extraordinary interventions in an effort to avert an economic and financial collapse. Central banks cut already low interest rates to close to zero and they engaged in quantitative easing (QE). The Bank of England announced £745 billion of asset purchases, while the Federal Reserve’s balance sheet has grown by almost £3 trillion since December. The credit rating agency Fitch has calculated that global asset purchases by central banks will exceed $6 trillion by the end of the year, over one-quarter the value of US GDP before Covid-19.
Such interventions have a direct effect on the stock market by loosening monetary conditions, with many interest rates across the maturity and risk spectrum falling. This tends to increase the price of financial assets such as share prices.
The main effect, however, may be indirect: unconventional monetary policy signals to the market that the authorities will intervene during future crashes, greatly reducing the systemic risk involved in investing. Research by Delle Monache et al (2020) on long-term stock market valuations is consistent with the view that the stock market bounce has occurred because of the decline in interest rates during the pandemic.
Related question: How did central banks respond to the coronavirus crisis?
Related question: Quantitative easing and monetary financing: what’s the difference?
Has good news about future profitability been driving the stock market bounce?
The bounce in the stock market has clearly not occurred in response to good news about the economy. A vaccine has not been developed, and economies are undergoing some of the largest falls in their GDP history.
A more plausible explanation is that there has been good news for certain business sectors, and these sectors constitute a larger proportion of the stock market than they do of the economy as a whole.
For example, the pandemic has increased demand for the services and products of very large technology companies. These companies have been at the forefront of the market boom: the NYFANG index of shares in Facebook, Amazon, Apple, Netflix and Google has risen by 64.6% since the start of the year, whereas the overall S&P 500 has risen only 1.9%. This may explain a large part of the bounce.
Related question: Has coronavirus made anyone better off?
Related question: How have Big Tech and other digital platforms fared in the crisis?
Should we be worried that there is a bubble in the market?
Nobel prize-winning economists such as Robert Shiller (2020) and Paul Krugman (2020) have suggested that the recent rise in share prices has been too large to be explained by fundamentals alone. Similarly, Cox et al (2020) suggest that the recent bounce is largely driven by sentiment, and Cappelle-Blancherd and Desroziers (2020) describe the link between share prices and fundamentals as loose.
This raises the possibility, popular in discussions on social media, that the stock market is now in a bubble. While the word ‘bubble’ is often used to express a general belief that share prices are too high, in academic research on finance, it typically refers to a substantial rise in prices followed by a crash – as Charles Kindleberger (1996) put it in his book Manias, Panics and Crashes: A History of Financial Crises, ‘an upward price movement that then implodes.’ The word ‘bubble’ may also imply that this occurs for no obvious fundamentals-based reasons (Goetzmann, 2016; Greenwood et al, 2019; Quinn and Turner, 2020).
What are the warning signs of a bubble? In their study of 300 years of bubble history, Quinn and Turner (2020) suggest that bubbles have three necessary conditions: speculation; an abundance of money and debt; and marketability. Are these conditions present in today’s stock market?
Speculation is the investment strategy of buying assets you expect to rise in price in the short term, hoping to make a quick profit. John Maynard Keynes (1936) defined it as ‘forecasting the psychology of the market’, as opposed to investing based on fundamentals.
Speculation is difficult to observe directly, but it is strongly suggested by the recent rise in the number of day traders – a common feature of historical bubbles. Several commentators have spoken of a ‘retail trading boom’, with share trading apps such as Robinhood in the United States and IG in the UK reporting unprecedented levels of new sign-ups during the pandemic. The major Chinese trading apps recently reported that the level of traffic was overwhelming their networks.
Money and debt provide the fuel for bubbles. Near zero or negative real rates on savings accounts and safe assets such as government bonds encourage investors to reach for yield (Acharya and Naqvi, 2019). Walter Bagehot once observed that ‘John Bull [the national personification of England] can stand a great deal, but he cannot stand two per cent… Instead of that dreadful event, they invest their careful savings in something impossible.’
The ultra-low interest rates that have prevailed since the pandemic hit in March will therefore not only have raised prices by lowering the discount rate, but will also have pushed investors to move into shares, and possibly into riskier parts of the stock market. Low interest rates along with easy credit mean that investors can more easily obtain margin loans to speculate in the stock market. Notably, the new zero-commission brokerages offer margin loans to their retail clients.
Marketability, similar to liquidity, is the ease with which an asset can be bought and sold – bubbles cannot happen unless assets can be easily traded. The rise of online trading means that the marketability of assets is now at an all-time high, and has more recently risen due to the aforementioned surge in the use of trading apps. Many brokerages have also increased the marketability of shares to retail investors by allowing fractional trading whereby investors can buy a fraction of a share like Amazon, which trades at over $3,000 per share.
Thus, the three necessary conditions for a bubble appear to be present at this moment. But all historical bubbles have been sparked either by radical new technology or by a new government policy. The technology shares that have driven the stock market bounce are by no means new technology – these are established companies and technologies benefiting from an increase in demand.
New government policy that leads to bubbles is much harder to identify. One potential spark occurred in March of this year, when central banks used unprecedented QE to arrest a stock market crash that was on a par with the historic falls in 1987 and 1720. Speculators may have been emboldened by the realisation that the authorities are effectively underwriting the stock market. Only time will tell if this has been the case.
If there is a bubble, will its popping create problems for the real economy? Bubble history helps us to understand whether the bursting of a bubble will be benign or economically destructive (Quinn and Turner, 2020). Politically sparked bubbles that were fuelled by bank lending have been the most destructive, whereas those that were sparked by new technology and were not fuelled by debt were the least destructive.
For policy-makers, the question that matters most is not whether share prices are too high: it is how exposed the financial system would be if share prices were to fall.
What else do we need to know?
We need to know the extent to which extraordinary monetary policy interventions and the lowering of interest rates have encouraged investors to reach for yield.
We also need to know the effect of the growth of day traders, zero commission brokers and fractional share trading on share prices and markets.
Finally, given that historical bubbles that are fuelled by credit and margin loans caused more economic damage after they burst, we need to know the extent to which investors are leveraged, and the extent to which the banking and shadow banking systems are exposed.
Where can I find out more?
- COVID-19 and the stock market: long-term valuations: David Delle Monache, Ivan Petrella and Fabrizio Vendetti suggest that the expected income on government bonds is driving stock markets.
- The stock market and the economy: insights from the COVID-19 crisis: Gunther Capelle-Blancard and Adrien Desroziers argue that the link between share prices and fundamentals has been loose during the coronavirus crisis.
- What explains stock market reactions to the pandemic? Gareth Campbell looks at the initial reaction of global stock markets to the pandemic.
- Which firms and industries have been most affected by Covid-19? Nicholas Bloom and colleagues look at the differential impact of coronavirus across firms and industries.
- Understanding the pandemic stock market: Economics Nobel laureate Robert Shiller looks at the role of crowd psychology, the virality of ideas and dynamics of narratives in explaining the bounce of the stock market.
- A podcast on the history of financial bubbles: William Quinn and John Turner explore the causes and consequences of historical bubbles, discussing their book Boom and Bust.
- Market madness in the pandemic: Economics Nobel laureate Paul Krugman argues that the large bounce in the US stock market is sign of irrational exuberance.
- Is there a bubble in the stock market? William Quinn and John Turner examine the necessary conditions in historical bubbles.
- Prospering in the pandemic: The top 100 companies: Financial Times coverage of stock market winners during the crisis.