Is the Bubble going to burst for US stocks?

American equities are currently trading near or at all-time highs despite operating in a country that was worst hit by Covid-19 pandemic in the year 2020. Key benchmark indices such as the S&P 500 index, Dow Jones 30 index, and the Nasdaq 100 index are all trading at alarmingly high valuations.

Investors are beginning to question whether the stock prices reflect the real valuation of the companies. Some investors in Wallstreet are saying that the markets have run out of control and have become purely speculative. Key technical indicators are screaming overbought on US equities.
Key Takeaways

• It is evident that US stocks are in a bubble since stock market prices are highly overpriced
• The US may not continue the huge stimulus packages indefinitely without worrying about the inflationary effect on the USD.
• There are numerous signs of a stock bubble burst and the retail traders could be the ones to finally pop the bubble.

US Stimulus

Ever since the beginning of the pandemic, the US government has printed over 4 trillion dollars in a set of stimulus packages designed to support the economy recover from the effects of the virus. This new money boosted US equities as aggregate demand increased and the US protected firms by promising to buy unlimited risky assets in a program dubbed QE Infinity.
President Biden is looking to pass a bill in congress that will add $1.9T in the US economy to boost recovery. This is expected to boost American stocks to higher levels. However, there are lingering questions on how long the US can keep up the stimulus packages. The are also questions concerning the inflationary pressures arising from the stimulus packages and their effects on the bonds market.

Signs of a Bubble
A stock bubble is often comprised by a couple of warning signs. Based on recent stock crashes, the signs have been consistent. One key sign is over extended rallies on stocks. The other key sign is increased participation by retail and amateur investors who take advantage of a positive feedback loop. It is quite common for your distant uneducated uncle to be convincing everyone to buy stocks at the dinner table when a stock bubble is about to burst.

Extremely low interest rates are also a common prelude to a stock bubble. Due to covid-19, the FED lowered interest rates to 0.1%-0.25% range. This made access to capital significantly cheap in the US. However, due to lockdowns and other covid-19 restrictions, this cheap money was not fully injected into production and consumption. Cheap loans and stimulus checks in the US led to a higher demand for rallying financial assets such as stocks, cryptocurrencies, indices, and oil. The FED is now stuck with low interest rates as the economy reopens and people resume normal business. This economic environment is a serene breeding ground for a stock bubble.
Stock market bubbles often require a trigger for them to burst. For instance, in the 2007/8 stock market crash, the trigger was when Bear Stearns bailed out two of its hedge funds trading in subprime mortgages and later liquidated them. A year later, Bear Stearns, previously valued at $178 a share, collapsed, and was acquired by JP Morgan Chase for $2 a share. IndyMac and Lehman brothers followed later.

GameStop Saga
This year, r/wallstreetbets, a Reddit community, ganged up to buy Gamestop shares eventually pushing them up over 1500% in two weeks. This forced two hedge funds to liquidate their short selling positions at losses. The move gained support from Elon Musk, the worlds richest man, and a couple of other billionaires and organizations. This hunt for short selling hedge funds later spread to Blackberry, Nokia, AMC, Express Inc, and Koss Corporation.
If this trend continues, several hedge funds will lose big percentages of their fund and may be liquidated. This may trigger a sequence of events that could undoubtedly lead to the stock market bubble popping.

Downbeat Earnings
The companies missing their earnings expectations may accelerate this process as investors begin to feel the effects of the pandemic on their portfolios. So far in 2021, Tesla, MacDonald’s, Citigroup, and Wells Fargo have missed their earnings expectations and more companies could follow.

Rufas Kamau
Research & Markets Analyst