Stock Market Superbubble
We are once again witnessing a pretty familiar scene. The bears are “out in force” as the US market hits correction mode.
While we are yet to be in bear market territory, there is already an expert out there who warns of a 70% pullback amid an “extreme” bubble. John Hussman, the man who correctly predicted the dot-com bubble crash in 2000 and the US housing-led crash in 2007, believes that the condition is now ripe for an even more epic burst.
Another well-known fund manager, Jeremy Grantham of the GMO fund, believes that stocks are in super bubble territory and the sell-off has just started, with the ultimate “burst” likely to reach a market drawdown of approx. 50%.
At the start of Jan 2022, he published the article: Waiting for the last dance in which he highlighted that the equity market bubble will burst in due time. He followed up with another article 2 weeks later, this time titled: Let the Wild Rumpus begin in which he highlighted that characteristics of previous equity superbubbles are now evident in this cycle, and it is all ready to pop.
Well, we have got no lack of naysayers calling for a massive stock market correction through the past decade, one which keeps proving these “experts” wrong, with the market trending higher and higher.
Some believe that the bull market of the past decade has been “artificially inflated” by the actions of the Fed and at some point, it will all “come to roost”. I don’t disagree with that statement but the party has always been able to last much longer than most people expected, which kept me wondering if this party can indeed be “ever-lasting”, or at least what is required to be done to bring this party to a “screeching halt”.
I have written on numerous occasions that this party can go on and on, with the Fed keeping interest rates low and engaging in extensive Quantitative Easing actions. However, all of those actions would have to be reversed when they are forced to raise rates “prematurely” due to the effect of inflation.
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When inflation is no longer as “transitory” as the Fed describes, and becomes a permanent feature in our society, that is where the trouble begins.
History has shown that to effectively combat rising inflation, the Fed will need to raise rates. That is what the Fed is attempting to do, all with the hope of not derailing the recovery in the economy as a result of COVID-19, as well as the ongoing bull market.
However, the act of raising rates is not sufficient if inflation starts running wild. That act has got to be aggressive. This is where the Fed is caught in a dilemma. To be so “hawkish” and raise rates aggressively, which is likely the only solution to battle runaway inflation, the Fed risks spooking the market big time, thus leading to a short-term massive correction.
To not attempt to raise rates aggressively would probably extend the pain as inflation continues unabated and ultimately result in more pain for the “man-in-the-street” as they struggle to cope with rising prices on necessities.
So, while I have always been hesitant to join in the chorus, singing the bear market tune, as I know that without inflation forcing the hands of the Fed to raise rates, they can continue to play the music that gets everyone dancing along.
That last dance, as Jeremy Grantham, has put it, has now ended and we have got to be prepared for the aftermath (hangovers) that typically results from massive parties.
Is this stock market vampire truly dead?
Jeremy Grantham, in his latest write-up, describes the current stock market as being in the vampire phase, one where you throw everything you have at it: you stab it with Covid, you shoot it with the end of QE and the promise of higher rates and you poison it with unexpected inflation and still the creature flies.
Until just as you are beginning to think that the thing is completely immortal, it finally and perhaps a little anticlimactically, keels over and dies. The sooner the better for everyone.
Jeremy Grantham believes that the 3 characteristics that most stock market superbubbles exhibit is now evident in the current one:
- A speculative investor frenzy that generated stories for distant decades, which we have had for well over a year
- A penultimate blow-off phase where stock gains accelerate, as we had in 2020,
- And the ultimate narrowing phase – unique to these few stock market superbubbles – where a decreasing number of very large blue chips go up as riskier and more speculative stocks underperform or even decline, as they did in 1929 and 2000 and as they have done since February 2021
When all 3 characteristics are accounted for, retire to a safe distance and pray for a paradigm shift.
Well, I am no vampire killer, so I cannot say with certainty that this “immortal” bull market is now coming to an end.
However, I do believe that the most important metric here to watch is simply inflation data. How fast inflation is rising could determine the actions (or perhaps) inaction that the Fed will take, which will ultimately translate to market reaction.
If inflation data is coming in hotter than expectation, then the Fed should start to guide for faster rate rises and that is not going to paint a pretty picture for the stock market in the short term. But that might be the “bitter pill” required to end the “addiction” that we have been so accustomed to all these years.
If the Fed decides to take its time to raise rates despite clear signs that inflation is getting out of hand, that might “soothe” the market temporarily but they will soon come to realize that such inactions or slow actions isn’t going to magically resolve the problem and the medium-term consequences might then be dire.
If inflation, for some magical reasons, decides to “play ball” and trend lower, then we will likely have a very “short-lived” bear market and the bull will likely be in control once again.
So, what can you do to prepare your portfolio in 2022?
Stock market super bubble 2022: How to position?
Again, I am no expert calling for a stock market correction of 50-70% in 2022. It might happen, it might not.
As I put on my long-term investor cap, I welcome these huge corrections so that I can finally deploy my more capital into the market. Don’t get me wrong, I am not trying to time the market per se by looking to go all 100% in cash and waiting for that “mother of all crashes” to happen.
My core strategy has still been to progressively dollar cost average into the market, with a long-term horizon. I remain committed to dollar cost averaging into my NAOF portfolio, one which I believe will be able to outperform a bear market crash significantly. I have explained how an investor with a small monthly capital interested to dollar cost average into such a portfolio can do so with relative ease using the latest Syfe Trade platform that allows an investor to engage in fractional investing.
But, I also do have spare capital specially reserved for such massive correction. That is the time when there is blood splattered all over the market, with most people “stunned” into inaction. That is the time that if you have got spare capital to deploy, “cash is indeed king”, just like how Warren Buffett’s Berkshire Hathaway has accumulated more than a hundred billion in cash to “pounce” when the opportunity presents itself.
That opportunity could finally be in 2022.
Coming back to Jeremy Grantham again, he believes that Value will more significantly triumph over its Growth counterpart in 2022, hence a long-short strategy will generate significant alpha in the current year.
Alternatively, if you are going long-only, then focus on non-US stocks in the Value category, including those in emerging markets and Japan.
Focusing on quality is also another strategy that GMO recommends, companies with deep moats, low levels of leverage, and consistent, high profitability.
I have written about finding quality companies in the past, a strategy to beat the market in both an inflationary as well as stagflationary environment.
Additional Reading: How to beat inflation in 2022 with these simple stock strategies
Additional Reading: Stagflation Investing. How to position your portfolio
I believe that if we are looking at a combination of inflation and higher rates taking place in 2022, then such an environment will not bode well for loss-making growth stocks.
While many of them have already corrected in the arena of 50% from their all-time high registered in early 2021, that drawdown can worsen in a rising rate environment also characterized by rising inflation.
Would you have the conviction that these loss-making growth stocks can turn the corner?
Would you have the conviction to double-down on these stocks, just like Catherine Wood, as they are now in “value” territory (based on a lower P/S multiple since they are still not generating any form of earnings and cannot be claimed to be “cheap” on an earnings basis)?
I cannot speak for everyone but I do personally also hold some of these loss-making growth stocks (Zoom, Teladoc, Snap, etc, just to name a few) which are currently “deep-in-the-red”.
Fortunately, my position in them is small and I have the comfort to dollar cost average into some of these stocks which I believe might be the future market leaders of their respective industry. I just have got to be able to stomach that pain and continue to believe in them. I could however, be dead wrong and that is where having a diversified portfolio of these growth counters ensure you don’t “blow-up” your account with just a handful of growth stocks that you have fallen in love with.
On the other hand, I have also increased my allocations into “hedges” which I believe will do well in both a rising rate and inflationary environment.
Conclusion
The end of the party that the bears have been trumpeting all these years might finally be here in 2022.
I feel that the risk (severe stock market correction) we are facing in 2022 is stronger due to one key reason: Inflation
Inflation is now at a level that we have not seen since the early 1980s and if that situation is to worsen, then you better count on the Fed to raise rates aggressively to curb its rise. If they choose to take a laissez-faire approach and raise rates “slowly” then we could ultimately risk the next “black swan” event: Stagflation.
If inflation forces taper off miraculously, then the party can get started once again.
For those who are long-term investors, I believe it makes sense to stay committed to your investing journey instead of looking to “time” that market crash. Again, there is no certainty it will happen. However, take this opportunity to sell off some of your losers that have no “hope” of recovering and recycle them into great companies going at a discount. I have written a simple 3-steps process that one can engage to prepare for a bear market.
Additional reading: How to prepare for a bear market. A simple 3-steps process
Look for portfolio “hedges” that will do well in the current context of rising interest rates and inflation.
Additional Reading: Interest rate hikes are coming in fast and furious. How to prepare your portfolio for it.
Once again, this article is by no means a recommendation to buy into any specific stock counter but a general piece that highlights my current thoughts as well as some strategies one could take in lieu of the current stock market context.
Do continue to engage in your due diligence process.
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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only
