People are hell-bent on calling something — anything — a ‘bubble’.
My guess is that most of it comes down to ego. There are still plenty of red faces embarrassed that they didn’t see the US housing bubble coming. So they overcompensate. As in the case of the US stock market.
Last Thursday, the Dow Jones Industrial Average cracked its fifth 1,000-point milestone this year. Something it’s never done before. It took only 30 trading days to go from 23,000 to 24,000 points.
The Dow sits at 24,290 as at this morning, up 22% in the year-to-date. There’s every chance that it will storm to 25,000 points before Christmas.
For all its gains, though, the Dow doesn’t reflect reality anymore. It’s no longer an effective measure of the productivity of the US economy. Out of the 30 stocks listed on the Dow, eight are consumer stocks. Bump that up to 11 if you include banks and credit card companies.
Basically, today, the Dow is an index that tracks US consumption.
Then there is the S&P 500. A far more useful tool when it comes to analysing the performance of the broader US economy. The index is up 16.9% for the year.
However, most of that has been driven by five key stocks — the FAANG stocks. Facebook, Inc. [NASDAQ:FB], Apple Inc. [NASDAQ:AAPL], Amazon.com, Inc. [NASDAQ:AMZN], and Netflix, Inc. [NASDAQ:NFLX] and Alphabet Inc. [NASDAQ:GOOG] have increased their market capitalisation by 30% this year. The remaining 495 stocks listed on the S&P 500 have only increased their market cap by a paltry 5.5%.
Some punters reckon tech stocks are in a bubble.
However, rather than picking one sector of the market and calling it a bubble, there’s a new phrase going around: The Everything Bubble. It basically assumes the entire US market is on the verge of popping.
This may be true.
Sometime early next year, global stock markets will be worth US$100 trillion. That’s U$40 trillion more than the value of stock markets during the GFC peak. Yet this figure only looks at stock markets. It doesn’t include derivatives like futures or options.
But it’s what happens behind the scenes that should concern investors. US stocks may look expensive. But what if the problem is much bigger than just the stock market?
Globally, stocks may be about to top US$100 trillion. But the total global derivatives market has a ‘conservative’ estimate of US$544 trillion. A high-end estimate is US$2.1 quadrillion.
A quadrillion. That’s not a number you hear everyday. Quite frankly, it’s too big to comprehend.
The global economy hasn’t had a great experience with derivatives in recent history, as you are no doubt aware. You’ll remember that derivatives copped the blame for the financial panic in 2008.
The whole idea behind a derivative is that its price comes from an underlying product of some sort.
Despite the technical name, derivatives aren’t a modern market marvel.
They originated in medieval times. A ‘fair letter’ would be drawn up between a buyer and seller of agricultural products, acting as a line of credit to use at trade fairs. Essentially, they were a promise to settle the account with gold.
Over the following several hundred years, the fair letter became a way for farmers to guess the value of their crop at harvest time, protecting their income.
Thanks to deregulation in the 1970s, they morphed from a hedging tool to the ‘Frankenstein of the market’.
Credit default swaps, for example, really only became popular in the early 90s. They were supposed to act as a form of insurance for a ‘collateralised debt’. That is, a debt a bank held that was backed up by some sort of security.
Shortly after this, the synthetic collateralised debt obligation (CDO) was popularised. CDOs were a bet on the performance of a credit default swap.
And just like that, you had a derivative on a derivative.
Knowing this, which estimate do you think is right regarding the size of the derivatives market: US$544 trillion or US$2 quadrillion?
In truth, no one knows for certain. Which means it could be far, far bigger than you imagine.
You can’t beat them, so join them
There is something strange afoot in the markets. I couldn’t tell you what it is. But markets are screaming ahead with no real reason as to why they should be.
Bloomberg reported yesterday that the surge in equities — especially in the US — comes on the back of very low volatility. In other words, the US market is rising as there are fewer participants. And the ones that are there are mostly buyers, with fewer sellers in the market to push back on rising prices.
One reason for this is the rise in passive investing at the expense of active investing. Exchange traded funds (ETFs) are growing as a way to ‘set and forget’ when it comes to investing.
In January, Forbes declared ETFs were ‘eating’ the US market.
In the year-to-date, the US ETF market has seen US$385 billion flow into the sector, including US$56 billion in October alone. US ETFs now have US$3.2 trillion under management.
It turns out people are mostly buying the ‘cheap’ index funds simply to get into the market and are then checking out.
However, the alarming rise in ETF investing should concern investors. ETFs are now becoming so big that they are effectively moving the market. After all, there are only so many places to dump billions and billions of dollars.
Yet Sam Volkering, editor of Secret Crypto Network, takes a different view. While the amount of people dumping money and running worries him, he wonders if there are two types of investors out there at the moment: Those willing to dump cash in an ETF, and those looking for something the enormous fund managers can’t touch yet. As Sam told me:
‘Maybe that’s why the crypto thing is blowing up. It’s one of the realms of opportunity that the giant ETFs aren’t touching yet and haven’t bastardised — and probably can’t bastardise.’
The crypto market is still only worth US$200 billion. It turns out the ‘big boys in the bubble’ can’t touch it yet. But you can.
Editor, Markets & Money