Ray Dalio’s “Bubble Indicator” Is Sounding The Alarm

Ray Dalio’s “Bubble Indicator” Is Sounding The Alarm
Reda Farran, CFA

about 3 years ago3 mins

What’s going on here?

With investor euphoria pushing US stock indexes to record highs, many fear a bubble is forming. Figuring out whether stock prices are due to drop is obviously of crucial importance – and so in order to put this thesis to the test, I’ve turned to a technique pioneered by legendary investor Ray Dalio, founder of Bridgewater Associates, one of the world’s largest and most successful hedge funds, and arguably one of the foremost experts on market bubbles.

What does this mean?

Dalio defines a bubble as an environment of unsustainably high prices, and his bubble indicator is based on asking six key questions with reference to several different statistics. Crunching these calculations for individual stocks allows us to then build an aggregate picture of an entire market and compare it to the past. The six questions are:

1️⃣ How high are stock prices relative to traditional fundamental measures of value like earnings or book value per share? For US stocks, this measure is currently way up in the 82nd percentile relative to the past 110 years.

2️⃣ Are prices discounting unsustainable conditions? This involves assessing the company earnings growth rates required for stock returns to outperform bonds. On this basis, US stocks aren’t actually too bubbly right now – probably because super-low bond yields are hardly difficult to beat.

3️⃣ 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. Today’s influx of retail investors into much-hyped stocks echoes the buildup to both the 1929 and 2000 market bubbles.

4️⃣ How broadly positive is investor sentiment? If it’s too bullish, then many investors may have already invested everything they’ve got – meaning they’re more likely to be sellers than buyers. This measure is presently flashing a little red for US stocks, driven by extreme bullishness in certain corners of the market: think emerging-technology, IPOs, and special purpose acquisition vehicles (SPACs).

5️⃣ 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 – notwithstanding retail investors’ highly leveraged purchases of popular stocks using call options.

Single-stock call option volumes are at record highs (Source: Bridgewater Associates)
Single-stock call option volumes are at record highs (Source: Bridgewater Associates)

6️⃣ Are businesses investing in their futures? Looking at 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 going forward. And while perhaps skewed by the effects of the pandemic, weak company spending leaves this the most placid-looking of all our bubble-indicating metrics at present.

Why should I care?

The table below shows what these six measures are saying today, both about the US stock market as a whole and emerging-technology stocks in particular – often flagged as an especially expensive sector. This might include shares of companies operating in areas like green energy, electric vehicles and autonomous driving, batteries, genomics, robotics, and so on.

Current conditions compared to previous bubbles (Source: Bridgewater Associates)
Current conditions compared to previous bubbles (Source: Bridgewater Associates)

The chart below, meanwhile, shows our composite bubble measure as applied to US stocks over the last 110 years and expressed using percentiles. Simply put, the higher the reading, the more our indicator implies a stock market bubble.

US stocks are currently sitting at the 77th percentile (Source: Bridgewater Associates)
US stocks are currently sitting at the 77th percentile (Source: Bridgewater Associates)

In short, Dailo’s indicator seems to be saying that while the US stock market overall is a little bit frothy, it isn’t (yet) in an outright bubble. At the same time, however, emerging-tech stocks are – in scenes reminiscent of the 2000 dotcom bubble.

So what should you do with this information? Perfectly timing the markets is notoriously tricky, if not impossible. But Stéphane’s recent Insight could help you hedge your risk if US stocks in general get any hotter – and if you’re invested in emerging technologies, then it might be worth reducing your exposure now. Significantly, this bubble indicator has proved to be a pretty good guide to stock performance over the subsequent three to five years…

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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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