If it Looks like a Bubble and Swims like a Bubble...
The insatiable demand for IPOs, the frenzy buying in blank check SPACs, the proliferation of amateur investors from Robinhood and other online trading upstarts, the frothy valuations in stock market indexes, elevated retail participation in financial markets, easy money from the FED and central banks, historically low or near-zero interest rates, massive fiscal stimulus programs, overly optimistic expectations of the COVID-19 vaccine, and widespread expectations for a quick reopening of the global economy.
Many on Wall Street and Main Street are increasingly concern about the strong parallels between the dot-com bubble era and today.
So, is the long bull market from 2009 inflating toward another full-size and epic bubble?
Based on the above, it is understandable why so many investors are concern about the potential for another bubble. The stock market has recorded unprecedented gains in a relatively short period. Pockets of the market are showing signs of bubble-like sentiments. However, does this mean that we are currently experiencing a financial bubble?
It is difficult to predict a stock market bubble. It is even harder to forecast a stock market top. Some claim that it is an exercise in futility. We wholeheartedly agree. Nonetheless, the characteristic of bubbles is the disbelief by most participants that it is a speculative price surge when it is occurring. It is only after the fact or after the bubble has burst that one recognized that it was indeed a bubble. Bubbles and speculative rallies tend to be deceptive and unpredictable.
By understanding the five stages of a bubble and by quantifying the extent of the price acceleration via technical indicators such as the Distance from the Moving Average (DMA) and Relative Strength Index (RSI) may help investors better prepare for them. The five phases of a typical bubble are displacement (new paradigm), boom, euphoria, profit-taking, and panic. Are we currently moving into the boom or euphoria phase of the five-stage bubble process?
Fundamental Analysts tend to value securities and market indexes by evaluating financial ratios such as Price Earnings (PE) and Earnings Per Share (EPS). On the other hand, Technicians tend to use technical indicators such as moving averages to help determine the extent of a bull rally. One popular technical indicator is the distance from the moving average (DMA). It is a moving average indicator that measures the distance (in the percentage) of how far above or below security is from its key moving average (i.e., the 50-day and the 200-day). The objective is to determine if a price move is overextended and if the price momentum is accelerating at an unsustainable pace.
Remember, moving averages are lagging indicators and are useful for filtering the noise and fluctuations in the market over a specified period. It indicates the strength of a trend rather than predict the movement of the security or market in question. The distance from the moving average indicator (DMA) can be a good indicator, primarily because of its simplicity.
However, the greatest value of this indicator is in helping to better understand the following market conditions. (1) Determine the primary trend in play (uptrend, downtrend, sideways trading range). (2) Decipher whether the trend is trading at an overbought or an oversold level. (3) Alert traders and investors to an impending retracement, reversal, or continuation trend based on the relationship between the distance between its moving average and the current price.
Since the dot.com bubble is a widely researched and well-publicized bubble phenomenon, we will compare the markets during the 2-year window leading to the bubble burst (March 2000) and contrast that market period to the current 2-year market environment. Two popular technical indicators - the distance from moving average (DMA) and the Relative Strength Index (RSI) will be applied to four major US stock market indexes - the S&P 500 Index (SPX), Dow Jones Industrial Average (INDU), Nasdaq Composite Index (COMPQ), and the Nasdaq 100 Index (NDX). The objective of this technical exercise will focus predominately on COMPQ and NDX and determine if there are sufficient similarities between the two time periods to warrant a bubble.
1998-2000 Time Period
We start with COMPQ and NDX entering cyclical bear declines during the height of the Emerging Market Debt crisis. From July-October 1998, COMPQ plummeted at -33%, and NDX suffered a -28.5% collapse. From the Oct 1998 market bottoms to the dot.com bubble bursting in March 2000, both markets would quickly move through the boom and euphoria phases of the 5-stage bubble process. In the process, COMPQ soared nearly 278%, and NDX skyrocketed an astonishing 353%.
The two leading technical indicators were quite useful in alerting investors and traders to an impending stock market bubble and a market top.
By the end of the first quarter of 2000, the 50-day DMA for COMPQ traded to an extreme high of 21.30%. The 200-day DMA spiked to 55.98%, and RSI overbought/oversold indicator recorded a high of 86.74 (January 2000). During a similar period, the technology-laden NDX recorded a 50-day DMA reading of 24.23% (January 2000). The 200-day DMA reading traded to a high of 59.37% (March 2000), and the RSI indicator jumped to 84.92 in early-2000.
2019-2021 Time Period
If we fast forward to the past two years, some similarities exist between today and the dot.com era. During the height of the COVID-19 induced recession from 2/19/20 to 3/23/20, COMPQ also plummeted 32.5% in less than one month. The NDX index collapsed 30.5% in less than one month. From March 2020 lows, COMPQ soared 107%, and NDX skyrocketed 100% in the last ten months.
The 50-day DMA indicator for COMPQ is currently trading at 8.22%, its 200-day DMA indicator is at 24.63%, and the RSI indicator is 74.22. For NDX, the 50-day DMA is trading at 7.19%, its 200-day DMA is at 22.01%, and the current RSI is 69.20. Although both DMA indicators are currently trading at extended levels, they are not as stretched as the dot.com period. Also, RSI readings are trading at overbought levels. However, in early 2020, ahead of the COVID-19 pandemic, the RSI reached an extreme level well into the 80s range.
A flood of IPOs, amateur traders chasing stocks, speculative behaviors from retail investors, easy monetary policies, massive fiscal policies, excessive equity valuations, and historically low interest rates are often classic signs of irrational exuberance. We respect the numerous market pundits and experts calling this a bubble as the similarities have grown too strong to ignore.
However, the current market environment does not resemble the dot.com era, not yet and at least based on the two technical indicators. For one, the sharp and explosive rallies of 278% and 353% in COMPQ and NDX far exceeds the current returns of 107% and 100%, respectively. Second, and most important, extreme profit-taking is one of the hallmarks of a bubble. We suspect that it will again reappear but probably when stock market returns have appreciated further.
Of course, some will argue that this time around is different. As always, we recommend investors and traders continue to monitor the recent rallies for signs that the market has indeed moved beyond the boom and euphoria stages of the five-phase bubble cycle and is transitioning toward the fourth phase or the profit-taking stage.