There are many ways to interpret the epic wave of GameStop (NYSE 🙂 in January. It can be seen as a big battle between small private investors and the big guns of the establishment on Wall Street; it can also be seen as the democratization of investing when the trade proletariat active on social media challenges the financial elite.
But Reddit traders chasing a handful of the most short-circuited stock names are also a clear signal of a bubble in the markets after a period of historically low interest rates and unprecedented monetary stimulus to fuel the global economy during the pandemic. to provide.
Of course, there is no sure way to predict a bubble in the making for each asset class, but there are some fairly similar warning signs that appear before an asset's value exceeds its realistic value. Charles Kindleberger, in his classic Manias, Panics and Crashes, provided the necessary conditions: easy money to make and an exciting story that will encourage people to invest.
The GameStop frenzy, which increased the stock price of this small-known retail chain 1,600% this month and forced some hedge funds to take massive losses to cover their short positions, couldn't possibly have happened unless the tens of thousands average Joe day traders involved did not have easy access to liquidity and a lot of time to trade from their bedrooms.
In addition to the GameStop drama currently unfolding, there are many other signs supporting the argument that markets are in classic bubble territory.
Look at the rollercoaster ride in cryptocurrencies and skyrocketing share prices from clean energy producers. And of course, who could forget the dazzling rally in Tesla stock (NASDAQ :), which jumped more than 720% in 2020, while other small players in the electric vehicle market also got a boost.
] Sell signal?
The main force creating these bubble-like conditions is governments trying to fight national, pandemic recessions through monetary stimulus. They spent about $ 12 trillion in fiscal aid during the pandemic alone, according to Bloomberg. At the same time, the US Federal Reserve buys $ 120 billion in bonds every month to keep financing costs low in the world's largest economy.
Bank of America strategists warned last week that market overshoots could trigger a correction in the first quarter. this year with their Bull & Bear Indicator approaching a "sell signal".
"DC & # 39; s policy bubble fuels Wall St. & # 39; s asset price bubble," said the BAC team, led by Michael Hartnett, in a letter to customers.
"When those who want to stay rich begin to behave like those who want to get rich, it suggests a late-stage speculative eruption."
Analysts at Goldman Sachs said in a note that very fast-growing multiple stocks "appear frothy" and the boom in special-purpose acquisition companies (SPACs) is one of a number of "signs of an unsustainable surplus" in the US stock market. The recent surge in negative earnings stocks is also at an all-time high, they said.
How should long-term investors prepare, assuming the market is in a bubble or near bubble area?
A simple, sensible way is to avoid highly speculative bets like GameStop. Another course of action should be to stay away from the areas of the market that are frothy and consider investments that are not in the bubble area, such as financial services and some highly rated industrial stocks. Exposure to a large-cap dividend fund is another way to add stability and mitigate risk in anticipation of a possible market correction.
Bottom Line
It's hard to predict end-game on the GameStop, social media fueled mania. For long-term investors, this is a warning sign that could spike in the coming days, and is a good time to make smaller portfolio changes to moderate risk. That means increasing exposure to low volatility assets, increasing cash reserves, and adding assets that have a low or negative correlation with the stock markets.
