Summary
1. Editorial: bubble or no bubble? that’s the question…
2. Macro: overly impressive figures?
3. Asset allocation: too early to worry?
Editorial : Bubble or not bubble? That is the question…
Financial bubbles in stock markets are fascinating phenomena that capture investors’ attention. Defined as a rapid and often unjustified increase in asset prices, bubbles are followed by an equally rapid decline when they ‘burst.’ However, it remains to be determined whether it is indeed a bubble or a paradigm shift justifying the movement.
Identifying the presence of a financial bubble can be a major challenge, as there is no single, foolproof criterion to do so. However, several signs may suggest that a market is experiencing a bubble: rapid price increases, excessive speculation, high leverage usage, or detachment from fundamental indicators.
The big question for investors is whether to participate in these movements or stay on the sidelines. More importantly, for those who choose to dive in, it is crucial to know how and when to exit before the bubble bursts.
The decision to participate in a financial bubble depends on risk tolerance and investment strategy. Some investors are attracted to quick gains and are willing to take on high risks, while others prefer a more conservative approach, avoiding situations where potential losses could be significant. From experience, the real challenge lies in the duration of the period, which can vary greatly. FOMO, or “Fear Of Missing Out,” is a psychological and behavioral phenomenon particularly prevalent in financial markets. It describes the anxiety or worry about missing out on a potentially lucrative opportunity, often fueled by success stories of other investors or by high market volatility indicating quick gains. In financial markets, FOMO can lead investors to make hasty decisions, buying assets without solid fundamental analysis or following the crowd without considering their personal investment strategy. This behavior can be exacerbated by social media and online trading platforms, where successes are widely shared, while losses are often minimized or ignored.
The key to profiting from a financial bubble is knowing when to exit. Some strategies that investors can consider include setting price targets, monitoring technical indicators, or using stop-loss orders. However, during periods of high volatility, stop-loss orders may also be triggered by temporary price movements, resulting in premature exits or detrimental back-and-forth trades.
While more a risk management strategy than an exit strategy, diversification can help limit losses when a bubble bursts and reduce the risk that the fall of a single investment has a disproportionate impact on your overall portfolio.
It is important to note that not all bull markets or periods of high price growth are bubbles. Some situations may exhibit characteristics similar to those of a bubble without actually being one. Technological advancements can lead to rapid and legitimate revaluation of companies in growing sectors. These price increases may seem excessive, but they can be justified by long-term growth prospects.
Changes in monetary policies, consumer preferences, or global economic conditions can lead to structural changes in certain sectors or markets, thus justifying price increases. The distinction between a genuine financial bubble and price increases justified by fundamentals or structural changes is crucial. Making decisions based on a misinterpretation of market signals can lead to substantial losses or missed opportunities for gains.
Examining how current situations compare to historical financial bubbles can provide insights. Although each bubble has its own characteristics, parallels with the past can offer clues about market behavior. It is necessary to assess whether price growth is supported by strong fundamentals, such as revenue growth, innovation, and market expansion, or if it is primarily based on speculation and excessive optimism.
Financial bubbles are recurring phenomena in the history of financial markets, with several notable examples that have had a profound impact on the global economy:
· The Tulip Mania (1637): Although not directly related to stocks, the tulip mania is often cited as the first documented speculative bubble in history. In the Netherlands, the price of tulip bulbs reached irrational heights before collapsing abruptly.
· The Crash of 1929: The Great Depression that followed the stock market crash is a classic example of a financial bubble. Stock prices had soared to unsustainable levels in the 1920s, leading to a catastrophic collapse that plunged the world into a decade-long recession.
Dow Jones Industrial Average 1926-1931
Sources : Bloomberg, Richelieu Group
· The Internet Bubble (2000): also known as the dot-com bubble, it saw the values of internet-related companies skyrocketing without solid fundamental justification, only to collapse afterward, leading to a recession in the technology sector.
Nasdaq Stock Market Prices 1998-2001
Sources : Bloomberg, Richelieu Group
There have also been situations that resembled bubbles but were not necessarily so:
· Market Recovery After the 2008 Financial Crisis: Following the crash of 2008, financial markets experienced a long period of sustained growth, partly due to accommodating monetary policies by central banks. Although some feared a bubble, this growth was largely supported by improvements in economic fundamentals and corporate profits.
· The Technology Market During the COVID-19 Pandemic: During the pandemic, economic fundamentals and corporate performance indicators play a crucial role. Financial bubbles are characterized by valuations that cannot be justified by concrete economic data, while price increases supported by tangible improvements in revenues, profits, or sector prospects reflect legitimate growth.
Profit Margins of US Companies versus the S&P 500
It is essential to remember that even with thorough analysis, accurately predicting when a bubble will burst remains extremely difficult. Markets can remain irrational for longer periods.
The rise of artificial intelligence has captured attention in recent years. With significant advancements in areas such as machine learning, natural language processing, and robotics, companies operating in the AI space have seen their valuations soar. This has led to discussions about the possibility of a financial bubble.
· Many arguments suggest a Bubble
Some AI companies have reached high valuations, sometimes based more on perceived future potential than current financial results. AI is often portrayed as a revolutionary technology, which can encourage speculation and investment based on the fear of missing out (FOMO), rather than on solid fundamental analysis. Furthermore, it receives considerable media coverage, which can sometimes amplify enthusiasm and speculation without a full understanding of current technological limitations or challenges to overcome.
Time magazine cover September 2023
· However, there are arguments that significantly moderate this theory
Unlike other bubbles, progress in the field of AI is tangible, profitable, and has practical applications that are already transforming various sectors such as healthcare, finance, manufacturing, and entertainment. This suggests that enthusiasm around AI may be based on real technological advancements rather than solely on speculation.
AI has the potential to continue growing and evolving, offering new business opportunities and efficiency gains. This indicates that while some companies may be overvalued in the short term, the overall theme has significant growth potential. It is also important to recognize that AI represents a major technological advancement with nearly limitless application potential in almost every sector of the economy.
The adoption of AI by businesses and consumers continues to accelerate, fueling sector growth. This widespread adoption is a sign that AI offers real value, unlike past bubbles where the burst revealed a lack of underlying substance.
The progress made in the field of AI and its increasing integration into everyday products and services suggest that, unlike traditional bubbles, there is a solid foundation of growth and innovation supporting interest in AI.
Investments in AI are not only coming from speculators but also from major institutional players, including governments, universities, and leading companies in various sectors, who recognize the transformative potential of AI. These investments are often strategic, aiming to integrate AI into operational processes, products, and services, indicating a long-term approach.
The comparison between the rise of the internet in the 1990s and 2000s and the current development of artificial intelligence reveals interesting parallels, both in terms of societal and financial impact. These two technologies have sparked significant waves of innovation, transforming businesses, the economy, and society as a whole.
Just as the internet revolutionized how we communicate, work, and conduct business, AI is transforming a multitude of sectors by making processes smarter, more efficient, and more personalized. In both cases, the initial enthusiasm led to high valuations for companies associated with the technology, some based more on future expectations than current performance. Both the internet and AI have experienced rapid technological advancements, with new applications and services emerging at an accelerated pace, often changing the landscape in various fields and creating new economic opportunities.
However, there are also key differences between these two periods that deserve examination.
The Internet bubble of the 2000s was characterized by extreme speculation on dot-com companies, many of which had no viable business model or significant revenue. In contrast, while AI also sparks high speculation, it is already integrated into many existing processes and products, demonstrating its utility and added value. AI benefits from the lessons learned during the bursting of the Internet bubble, including the importance of solid fundamentals and practical integration into the real economy. Furthermore, AI technologies are often developed and deployed by established and profitable companies as much as by innovative startups.
Valuations have not reached the excessive levels of the 2000s.
In the case of Nvidia, the rise in stock price has been in line with the company’s performance. In terms of valuation, despite a increase of over 238% in 2004, valuation multiples remained stable, reflecting very high expectations regarding fundamentals, justified by the company’s latest earnings announcements.
Nvidia: price and price-earnings ratio
Sources : Bloomberg, Richelieu Group
While the internet primarily transformed information, communication, and commerce, AI has an even broader scope of application. The adoption of the internet followed a relatively linear path, from innovation to commercialization and widespread use. AI, on the other hand, evolves through more complex cycles of innovation, with advancements in machine learning, natural language processing, and robotics gradually integrating into existing products and services.
Although the current situation surrounding AI shares some characteristics with the early 2000s internet era, there are significant distinctions that suggest history may not necessarily repeat itself in the same way.
The experience gained since the bursting of the internet bubble has also led to a more nuanced approach to investing in emerging technologies, with increased focus on viable business models, creation of real value, and sustainable innovation.
Major internet companies such as Cisco Systems and Intel had failed to meet market expectations regarding earnings growth rates. These disappointments had led to a significant decline in the stock prices of these companies.
This does not mean there is no risk of overvaluation or market correction, but rather that investors, companies, and regulators may be better equipped to navigate the complexities of this new technological era. AI is likely to continue advancing and integrating into the fabric of the global economy, despite inevitable market fluctuations and ongoing challenges.
Historically, the ability to identify a financial bubble in real-time has often eluded even the most seasoned observers, mainly because the true nature of a bubble only becomes clear in hindsight. It is typically only after a bubble has burst, or when economic fundamentals have finally justified valuations initially considered exaggerated, that the situation can be accurately assessed. The first lesson to be drawn from this fact is the importance of humility in financial analysis. Predicting the future of markets, especially in such volatile and innovative fields as AI, requires acknowledging the extent of our ignorance. Financial markets are influenced by a myriad of factors, including human behavior, government policies, technological changes, and unforeseen global events, making predictions extremely difficult. We believe that the case of Artificial Intelligence is not a bubble in the theoretical sense but a genuine paradigm shift that will enable businesses to increase their productivity.
The extreme concentration poses a significant downside risk for the S&P 500 index.
This complexity underscores the need to approach investment and market analysis with caution and an open mind towards various possible scenarios.
Macro : figures too impressive ?
US Macro
Jerome Powell had positive comments on the macroeconomy, indicating that the acceleration in growth has not been accompanied by a simultaneous decrease in unemployment or a reacceleration of inflation. Despite his more optimistic forecasts for growth, the Fed believes that the disinflationary trend continues. However, the latest inflation figures are casting doubt, and some FOMC members may gain more weight in the debate. We now expect a maximum of 2 or 3 rate cuts. The first rate cuts would come this summer. It is possible that the Fed waits at least until December or January 2025 for the third cut. It should slow down the reduction of its balance sheet starting in May.
Fed Funds Rate and Market Futures Expectations
Sources : Bloomberg, Richelieu Group
The upcoming US elections mean that the Fed is facing ‘dilemmas bigger than those of the ECB’. If the Fed waits too long and cuts rates just before the election (September), it may be accused of aiding the current administration. If it does not cut rates until the election, waiting for inflation to fall further, it may be accused of aiding Trump’s campaign.
Economic indicators remain positive. We believe that US growth should slow throughout the year due to declining consumer confidence. The risk of recession is expected to materialize in 2025, pushing the Fed to cut rates more aggressively next year (4 cuts).
EUROPE Macro
The ECB should reduce its deposit rate by 25 basis points in June and July if it wants to buy some time over the summer without immediately sparking speculation about the timing of future easing. These 50 basis points would justify a wait-and-see attitude for a few months before the next move.
Tweet from the ECB
Sources : X, ECB Podcast (click here)
Unlike the Fed, the ECB would have no reason not to cut in June if its new projections confirm the March forecast for inflation at 2% in 2025 and below 2% in 2026, based on a yield curve incorporating a reduction in market rates in the coming months.
BCE Rates and Inflation
Sources : Bloomberg, Richelieu Group
Maintaining rates longer would imply a stricter monetary policy as inflation declines, with a view to a recovery that is just beginning to pick up steam, as indicated by recent leading indicators. The ECB is likely to remain data-dependent, even at the risk of falling behind on easing. If the economy truly rebounds in the second half of this year and inflation remains around 2%, there may be little room to lower rates below 3% in 2025. The composite PMI surprised on the upside in March at 49.9, signaling almost stagnation of activity in the area (49.2 in February) after 9 months of contraction!
Eurozone PMI
Sources : Bloomberg, Richelieu Group
Emerging Markets Macro
China has announced that it has filed a complaint against the United States with the WTO. Sino-American relations continue to deteriorate, and this may intensify as the US presidential elections approach. Even though authorities have announced a historic decrease in the reference rate for housing loans, this is expected to have only a relatively limited effect as weak demand primarily reflects a loss of confidence. However, the easing of credit conditions could weigh on banks, which are still heavily pressured by authorities to support the real estate sector and the Chinese currency. Nonetheless, this announcement illustrates the Chinese authorities’ willingness to show continued support for real estate through actions that remain targeted but more decisive.
Explanatory factors of Chinese growth
Sources : Bloomberg, Richelieu Group
Beijing seems to prioritize stabilization over large-scale stimulus, with a plan aimed at households still not on the agenda. Industrial production bounced back in February, along with investment, particularly in the manufacturing sector. However, as a sign of an economy facing declining consumer confidence, retail sales remained weak and slowed despite the New Year. While the industrial sector benefits from support policies implemented by Beijing, it’s noteworthy that consumption does not seem to receive the same attention from the authorities. Chinese growth will remain much lower than in the past, and it would require implementing new significant stimulus plans with clear effects on domestic household demand to achieve the announced target of “around 5%” (which seems unlikely to us). Structural vulnerabilities will weigh on the dynamics of Chinese growth, which will be more limited than in the past (with expected growth of +4.2% in 2024).
India’s commercial activity closed out this fiscal year on a high note, expanding at the fastest pace in eight months in March, according to a business survey, suggesting that the country would remain the fastest-growing major economy. The HSBC Purchasing Managers’ Index (PMI) for India, compiled by S&P Global, rose to 61.3 this month from 60.6 in February, thus extending the sequence of expanding activity to 32 months. Driven by the strongest manufacturing output in nearly three and a half years, the composite production index surged rapidly. However, overall price pressures increased this month. The Indian economy shows remarkable signs of strength, buoyed by a dynamic manufacturing sector and robust demand both domestically and internationally. However, challenges related to inflationary pressures require continuous monitoring to guide future monetary policies.
Indian PMI
Sources : Bloomberg, Richelieu Group
Asset allocation : too early to worry ?
EQUITIES
We are maintaining our neutral stance on equities for the time being. We remain in line with last month’s perspective: “We believe it is prudent to ride the bullish momentum in equity markets and anticipate a catch-up in the ‘cyclical’ theme that has lagged behind.” The upcoming decline in real interest rates appears to be already largely priced in by equity markets. The upside potential is limited. Emerging market indices, which have lagged behind, may now move in line with their global counterparts.
Major stock indices since November 1st
Sources : Bloomberg, MSCI, Richelieu Group
The rebound phase continues, and stock markets remain on a positive trend since Jerome Powell’s speech on November 1st, 2023, marking the end of an aggressive monetary policy to combat inflation. The catalysts for a correction are not yet present, although doubts arise regarding inflation and certain valuations in the United States.
The equity risk premium for developed markets is precisely in line with the historical average since 1990 (at 4.1% vs. average of 4.2%), implying that equity markets are well valued compared to bond markets in the current context.
Equity risk premium for developed markets
Source : Socgen
The theme of steady disinflation, providing room for the Fed to swiftly cut rates, is coming to an end. In the United States, the three major indices have been above their 50-day moving averages for 19 weeks, longer than all but three brief periods over the past 20 years (early 2011, early 2014, early 2018), with average returns over 3 months negative after these periods, which could weaken momentum on the eve of the first rate cuts. Moreover, market concentration remains at a historical high, potentially undermining the market by directly connecting it to specific themes (AI). Leading economic indicators show a strong momentum in the manufacturing sector (compared to stagnating services), which should lead the industrial sector to outperform.
PMI US Indicator
Sources : Bloomberg, Richelieu Group
The market generally declines after the initial rate cuts, leaving some time for a significant correction, but the closer we get to the debates on the presidential election, the more volatility will increase.
In the eurozone, the story is quite different. Economic growth is barely picking up, and the ECB will need to be much more accommodative. The real story remains for now a disinflationary process that is not being challenged, thanks, it is true, to very “moderate” growth. Another piece of good news: negotiated wages in the eurozone increased by 4.5% year-on-year in the fourth quarter of 2023, which would be slightly less than in the previous quarter (4.7%) and tends to show that the peak of wage growth is now behind us. The indicator of hourly labor costs is slowing significantly.
Eurozone: Evolution of Negotiated Wages, Hourly Wage, and Eurozone
As long as energy prices (gas and oil) do not show strong signs of recovery, the risk seems contained. Earnings per share (EPS) for 2024 have not yet been adjusted to reflect this dynamic. Valuation multiples should increase gradually, especially if central banks enter a real cycle of interest rate cuts and considering Europe’s historical discount compared to the United States. We favor cyclical stocks and the financial sector, which largely benefits from increased profitability and balance sheet strengthening in banks. Political risk remains moderate for the moment. We remain positive on the region, which we continue to overweight.
Natural gas and oil in Europe
Sources : Bloomberg, Richelieu Group
In the United Kingdom, stagflation truly comes to the fore. Sluggish economic growth and inflation more in line with that of the United States than the eurozone present a challenging dilemma. Containing inflation appears more complicated across the Channel, which will necessitate the Bank of England to remain more restrictive for a longer period compared to its European and American counterparts. This will continue to keep the currency at a high level, despite ongoing sensitive structural issues.
Sovereign rates
In the United States, our year-end target for the 10-year US bond yield is 3.80%, taking into account the economic slowdown towards the end of the year. The 2-year yield should align with similar levels, indicating the end of the inverted yield curve period. The reduction in the Fed’s monetary policy tightening should help avoid excessive pressure on sovereign rates.
10-year yields
Sources : Richelieu Group, Bloomberg
In the eurozone, spreads between countries continued to narrow as the logic of buyer “flows” and expectations of interest rate cuts continue to outweigh the reduction in the size of the ECB’s balance sheet. However, the potential for further downside is limited, especially in Italy, due to fiscal challenges in 2024 and beyond. We remain less comfortable in Europe than in the United States. US sovereign rates could benefit from recession fears towards the end of the year, while Euro rates could be impacted by budgetary drifts and concerns about credit rating downgrades. Emerging markets present better opportunities.
Source : X
CREDIT
The corporate Investment Grade and High Yield bond markets remain attractive despite compressed spreads for the latter, with yields being attractive ahead of the expected decline in interest rates, particularly in Europe (extension of duration).
In the US Investment Grade market, yields have been increasing since the beginning of 2024. We now anticipate a rate cut in the United States. While the expected economic growth slowdown is materializing, it will remain contained without a recession. IG spreads remain above their historical lows, except for AA-rated bonds. We prefer to position ourselves in the BBB-rated areas. The resilience of the US economy has allowed HY spreads to tighten in early 2024, with CCC-rated bonds being more volatile. The scenario of the Fed disappointing the market regarding its monetary policy should allow for moderation of Quantitative Tightening (QT) starting from May, benefiting only sovereign bonds. Conversely, maintaining higher-than-expected rates should weaken the most fragile segments. The risk of recession is expected to materialize towards the end of the year. We remain cautious on US High Yield.
Credit spreads
Sources : Bloomberg, Richelieu Group
In the Euro Investment Grade market, yields have risen by approximately 10 basis points since the beginning of 2024 amid a rise in interest rates. Spreads are expected to now move laterally compared to current levels. The low point of growth has been reached, or even exceeded, in Europe, while the expected slowdown in the United States is materializing but will remain contained. IG spreads remain wide compared to their historical lows, incorporating the weakness of growth in Europe as well as the planned withdrawal of the ECB. Credit risk is generally well compensated by yield. Reduced concerns about the risk of recession in the eurozone have allowed spreads of bonds rated B and BB to continue tightening towards lows in this segment. Attrition in the HY segment also fuels the supply/demand imbalance, while liquidity remains very significant. Our growth expectations do not completely eliminate the risk of seeing default rates increase, especially for bonds in the HY category. Risk on CCC-rated bonds remains high, particularly in connection with the increasing refinancing issue. Abundant liquidity among investors, combined with a decrease in interest rate volatility, benefits the primary market in 2024. Despite the end-of-year bond rally, investors continue to deploy their cash in primary operations, as absolute yield levels remain attractive and are expected to continue to attract. Bank credits continue to benefit from the quality of balance sheets, and the Credit Suisse episode is now largely behind us. We continue to favor high-quality hybrid and subordinate bonds.
OIL
The efforts of OPEC have paid off, but countries will soon want to reap the rewards. Long pressured due to the loss of credibility of OPEC+, Brent has managed to rebound thanks to a much stronger oil demand than anticipated by investors, but also due to the continued efforts of production cuts by cartel members. The latest cuts have been extended until the end of Q2, with an additional effort from Russia, but the return of Brent to higher levels should now encourage countries to discuss an increase in production, probably at the June meeting. We expect oil to be above $80 USD. Oil-related stocks should benefit from this environment. The productivity of US companies has improved significantly over the past several years due to various crises. The graph below showing the number of oil rigs considering production simply demonstrates this.
Sources : Bloomberg, Richelieu Group
Asset Allocation Table
Synthesis Strategy Richelieu Group – Author
Alexandre HEZEZ
Group Strategist
Disclaimer
This document was produced by Richelieu Gestion, a management company and subsidiary of Compagnie Financière Richelieu. This document may be based on public information. Although Richelieu Gestion makes every effort to use reliable and complete information, Richelieu Gestion does not guarantee in any way that the information presented in this document is reliable and complete. The opinions, views and other information contained in this document are subject to change without notice.
This document was produced by Richelieu Gestion, a management company and subsidiary of Compagnie Financière Richelieu. This document may be based on public information. Although Richelieu Gestion makes every effort to use reliable and complete information, Richelieu Gestion does not guarantee in any way that the information presented in this document is reliable and complete. The opinions, views and other information contained in this document are subject to change without notice.
The information, opinions and estimates contained in this document are for information purposes only. No element can be considered as an investment advice or a recommendation, a canvassing, a solicitation, an invitation or an offer to sell or to subscribe to the securities or financial instruments mentioned. The information provided concerning the performance of a security or financial instrument always refers to the past. Past performance of securities or financial instruments is not a reliable indicator of future performance.
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Market data is from Bloomberg sources.
