On Monday, the Federal Reserve Board released its bi-annual report assessing the resiliency of the U.S. financial system, otherwise known as the Financial Stability Report (FSR). The twice-a-year memorandum evaluates the United States’ financial health through research and data analysis within four broad categories of ‘vulnerabilities’ – characteristics of the financial system that accumulate over time, and pose the greatest risk to causing widespread problems in a time of stress. The four categories are:
Elevated valuation pressure on assets
Excessive borrowing by businesses and households
Excessive leverage within the financial sector, and
Of particular interest is category number one. More frequently now than at any other time in my career, clients are seeking insight on the equity markets. This is especially true of inquiries regarding valuations, SPACs, and the sheer number of new issues over the past 18 months. But in truth, these questions are derivative of a harder-to-answer core question – are current market characteristics the product of a speculative asset bubble?
The FSR, being a formal document, doesn’t make mention of a ‘bubble’ in its analysis of elevated asset prices, but it surely acknowledges that equity valuations are high. It’s actually the second FSR report in-a-row that notes as much. Per the report, a year-over year analysis of the total market size of equities (2020: Q2 – 2021: Q2) in nominal dollars shows almost a doubling (+47.2%). Further, when looking at the current valuation of equities as a function of forward-looking P/E, the report shows that equities haven’t traded at these multiple levels since 1999. In fact, in the past 25 years, at no other time except for the Dot-com peak, did equities trade at forward PE levels as high as they are today.
The takeaway one can (and should) draw from the most recent Financial Stability Report is that although the Fed won’t say it, the data they’re seeing supports the assertion that yes, indeed, we are in a speculative asset bubble.
I don’t think this conclusion surprises anyone.
What should be surprising, though, is the Fed’s rationale for why.
The FSR stitches together a compelling framework for explaining – at least partially – the factors contributing to equities trading at historically high levels of forward earnings. A focal point of this argument is centered around the rise of the retail investor, by way of behavioral changes, and structural changes to the system. The report contains a dedicated insert which explains these changes through an analysis of the highly volatile ‘meme’ stock trading and pricing action earlier this year, using AMC Theaters (AMC) and GameStop (GME) as examples.
The argument goes something like this:
The expansion in size (nominal dollars) and valuation of equity assets, is partially and likely attributable to retail traders. Structurally, the elimination of trading commissions and the proliferation of online trading platforms have provided heretofore non-market, retail participants unprecedented access to invest in equities. Technologically, social media platforms – Reddit, Twitter – have allowed for highly efficient, real-time communication between retail investors, creating a medium through which they can organize around an investment idea, and execute that idea, very quickly and at large scale. The consequence of these changes has created a fecund environment for new retail investors, especially younger ones (demographic change).
Access has never been greater. Trading costs have never been less prohibitive. And the proliferation of mobile trading applications combined with increased engagement on social media, has created a user experience on par with that perceived playing a video game (gamification).
In a nutshell – trading in equities has become cheap, fun, and easy.
But not so fast.
Though I find the Fed’s rationale regarding the surge in retail investing a compelling explanation for the surge in equity market size, and stretch in equity valuations, it’s bereft of one tiny, not-so-insignificant detail – where did these retail investors get their money?
Since the onset of the pandemic, the Fed has flooded the financial system with money. Both directly through open market bond purchases ( Note: per the Fed decision 11/4, it will begin tapering open market purchases of Treasuries and Mortgage-Backed Securities by reducing purchases by $15B each month ), and indirectly, in its normal function of exchanging government IOUs for credit to fund Congress’ fiscal stimulus.
As such, a more conspicuous absence of accountability and lack of culpability, I can’t imagine in any legitimate explanation for the rise of the retail investor.
The Fed is embracing what I like to describe as the Shaggy Defense – “It wasn’t me”.
That the Fed takes no responsibility for creating and facilitating the financial conditions wherein retail investors are awash with cash, and that cash, in turn, is making its way into equity assets, is obscene. And like Shaggy’s song, where the cheating partner gets caught in the act and still denies it, the Fed is doing the same.
Fintech investment bank – takeaways and segues.
Are we in a speculative asset bubble? Very likely, yes.
Is the surge in retail investment the cause? It’s one cause, but it’s hard to definitively say it’s the primary cause. Per the Fed, another cause of elevated equity valuations is more bullish, forward P/E analyst targets.
Is the Fed responsible for the speculative asset bubble? The Fed is partially responsible for the speculative asset bubble.
As it happens, the Fed’s report was released at roughly the same time that three of the biggest-name, publicly traded fintech companies released earnings: Paypal (PYPL), Square (SQ), and Coinbase (COIN). The equities of these companies help demonstrate the hallmark attribute of equity performance in any highly speculative, bubble-like market: historically high valuations.
Take a look at the simple table below. It’s clear that comparatively speaking, these companies are trading at historically high multiples compared to the NASDAQ 100. Bear in mind that these calculations, made Wednesday 11/10, also capture a post-earnings slide in share price for all three companies. This is significant because it means prior to the results, the respective P/E and Forward P/E ratios were higher than what the table shows.
Square earnings-per-share (EPS) came in as expected, but revenues missed (by a lot – $3.8B vs. 4.4B expected), and it pulled guidance.
Paypal beat both top- and bottom-line projections, but guided-down on revenue growth, attributable to the deceleration of online commerce resulting from easing brick-and-mortar constraints as pandemic severity recedes.
Coinbase beat on EPS, missed on revenue, and saw a meaningful drop in Monthly Transacting Users (MTU)s from the preceding quarter.
Hey Fed, it WAS you.