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We are in the "Mania Stage" of a Market Bubble says TS Lombard

Market bubble debate

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Stock markets are indeed in a bubble phase according to research conducted by economists at TS Lombard, the independent economic and investment strategy research provider.

Despite identifying the market as being in a bubble, strategists say it is too early to exit the market as doing so could risk missing out on substantial returns.

Therefore, staying invested is still important although investors are told that planning for an exit and rebalancing sector exposure would be prudent.

  1. Signs of a market bubble identified by TS Lombard includes:the surge in SPACs (What is a SPAC? As defined by Investopedia, a SPAC is a Special Purpose Acquisition Company, this a company with no commercial operations that is formed strictly to raise capital through an initial public offering (IPO) for the purpose of acquiring an existing company).
  2. extreme returns in unprofitable tech stocks
  3. margin debt is at a record high
  4. r/wallstreetbets now as important as regulatory news providers for equity traders

Anatomy of a bubble

Above: The anatomy of a bubble, as described by Prof. Jean-Paul Rodrique, image courtesy of TS Lombard.

The above chart shows a market bubble, as described by Professor Jean-Paul Rodrique. According to economist Oliver Brennan at TS Lombard, market behaviour certainly fits the "mania" phase – which is the phase before a fall.

"So, it is right to now be concerned about the risk of a pop amid evident retail-investor enthusiasm, especially for penny and most-shorted stocks," says Brennan.

TS Lombard do however say that low interest rates are however supportive of valuations and argue against the view that a bubble has formed.

Credit pulse

Above: Credit/GDP ratio is near a record high.

Credit Impulse

…but, allowing for borrowing costs, it’s not a risk

Economists note the Credit/GDP ratio is at a record high but when the ratio is reassessed as a credit impulse cost (y/y change in credit multiplied by the 5y bond rate as a proxy for interest costs), the results are more supportive of current market levels.

"This measure still captures the huge unsustainable bubble that formed in the early 2000s but right now suggests no risk," says Brennan.

Nevertheless, signs of market exuberance can be found elsewhere with equity market indicators said by Brennan to be much more frothy.

Investor long equity exposure is observed at 113% while even the most bearish quartile is 100% long.

This sentiment is reflected in a surge of new money coming into broker accounts with TS Lombard observing margin debt has risen by more than US$120BN in the last three months, making for the most rapid expansion of margin debt in recorded history.

"The current pace of margin debt expansion is right at the boundary between 'top of a normal range' and 'watch out, this looks like 2000 and 2007'," says Brennan.

Overall, TS Lombard say retail activity is a signal that the market is now in the mania stage of a bubble, and, "but in aggregate the equity market is not yet in the dangerous 'greed' or 'delusion' phase".

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But the problem for investors is that exiting the market too soon could mean they lose out on significant gains.

"Equity market rallies tend to accelerate before they finish: the last 12 months of a US market rally is worth on average +20%; the last three months is worth on average +10%. (These data cover the last 100 years but exclude the 2020 peak," says Brennan.

Therefore, timing the exit is crucial.

"The time horizon has never been more important," says Brennan. TS Lombard see the potential for further near-term gains, but the longer-term outlook is now a riskier prospect.

Macro Strategists at the firm have recently readjusted asset allocation by rotating back towards the “virus winners” (e.g. US equities) and out of value (e,g, Spanish or Italian equities).

We reported recently that economists at Bank of America say the stock market is not in a bubble and the rally of recent months could yet extend say analysts at a major Wall Street bank.

Bank of America's equity analysts say signs of "froth" in the market suggest to some that equities are in a bubble, but they argue a bubble is a price rise not justified by fundamentals.

"Market commentators point to increasing signs of froth as evidence that the equity market is in the late stage of a bubble, which is set to burst soon," says Sebastian Raedler, Investment Strategist at Bank of America.

"The key fundamental driver of equities is growth momentum, which is set to be exceptionally strong this year," adds Raedler. "We think this is not a bubble, but the pre-pricing of a growth surge, with our PMI projections implying 10% upside by Q3".

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