Is Ray Dalio’s “Bubble Indicator” Telling You To Buy The Dip?

Is Ray Dalio’s “Bubble Indicator” Telling You To Buy The Dip?
Reda Farran, CFA

almost 2 years ago3 mins

  • After a sharp market fall, the bubble indicator for US stocks currently sits in the 40th percentile, suggesting we’re no longer in a bubble.

  • But that doesn’t mean US stocks are a buy – they’re still overvalued, and discounting of future earnings growth is still higher than normal.

  • History shows that once the popping begins, bubbles often overcorrect to the downside versus settling at more “normal” prices.

After a sharp market fall, the bubble indicator for US stocks currently sits in the 40th percentile, suggesting we’re no longer in a bubble.

But that doesn’t mean US stocks are a buy – they’re still overvalued, and discounting of future earnings growth is still higher than normal.

History shows that once the popping begins, bubbles often overcorrect to the downside versus settling at more “normal” prices.

Ray Dalio – the billionaire founder of the world’s biggest hedge fund – is known for many things, but his “bubble indicator” might be his masterpiece. It’s based on six questions that help establish whether we’re in an environment of unsustainably high prices, and it was sounding the alarm about US stocks early last year. So let’s check back in and see whether that bubble is still intact…

What are Ray Dalio’s six questions?

1) How high are stock prices relative to traditional fundamental measures of value, like earnings or book value per share? Right now, this measure is roughly average. After the recent decline in US stocks, it’s currently in the 50th percentile relative to the past 110 years.

2) Are prices discounting unsustainable conditions? This involves assessing the corporate earnings growth rate required for stocks to outperform bonds. This measure has gone up over the past two years as bond yields have risen, which increases the hurdle for stock returns, and is now in the 60th percentile for US stocks. That is, the earnings growth discounted in stocks is a bit high, and this is even more noticeable in the US software sector.

3) How many new buyers have entered the market lately? A rush of new entrants, especially smaller players attracted by fast-rising prices, is often telling. This measure shot above the 90th percentile in 2020 after an influx of retail investors into much-hyped stocks. But more recently, retail activity in markets has drifted back down to pre-Covid averages.

4) How broadly positive is investor sentiment? If it’s too bullish, many investors may have already invested everything they’ve got – meaning they’re more likely to be sellers than buyers. That’s not the case now. Sentiment in the market is strongly negative, reaching levels we saw during the deepest depths of the dotcom bubble crash.

5) Are investments being financed by high leverage? Buyers who draw heavily on either margin (borrowed money) or leveraged products like options are more vulnerable to forced selling in a downturn. As things stand, the US market is OK overall, with this measure lying in the 50th percentile.

6) Are businesses investing in their futures? Companies’ spending on things like equipment and factories can reveal whether stock market optimism has infected the real economy, creating potentially unrealistic (and expensive) expectations of demand growth. This gauge is currently in the 40th percentile, or slightly lower than average, perhaps impacted by ongoing supply chain issues.

So what’s the bubble indicator showing?

The chart below shows the composite bubble measure as applied to US stocks over the past 110 years and expressed using percentiles. Simply put, the higher the reading, the more the indicator implies a stock market bubble. US stocks are currently sitting in the 40th percentile. That suggests we’re no longer in a bubble.

The bubble indicator on US stocks is sitting at the 40th percentile. Source: Bridgewater Associates
The bubble indicator on US stocks is sitting at the 40th percentile. Source: Bridgewater Associates

Now that the bubble’s burst, is it time to get back in?

Without the help of a crystal ball, it’s hard to give a definitive response to this question, but the short answer seems to be: no. See, while the market reversal has been significant, discounting of future earnings growth is still somewhat high compared to history – especially when a recession is believed to be looming. Plus, US stocks still look a bit overvalued by some measures.

History suggests that once the popping begins, bubbles often overcorrect to the downside – that is, they sell off more than the fundamentals would suggest, rather than just settling at more “normal” prices. And this overcorrecting can be a long process because bubbles often take a while to fully unwind: two years in the case of the 1929 bubble, and one year in the case of the late ’90s dotcom bubble. Put differently, just because stocks are no longer at a bubble extreme doesn’t mean they’re now a good buy. History suggests there’s more downside to come. And to quote Mark Twain: history doesn’t repeat itself, but it often rhymes…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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