I’d be a rich man if I had a dollar for every prediction over the last several years that the stock market was forming a bubble about to burst.
So far, of course, none of those predictions has come to pass. And, yet, investors have a hard time shaking that nagging feeling that the current bull market is characterized by unhealthy levels of speculation and even irrational exuberance.
Is there a way of quantifying the market’s bubble potential, which instead of relying on our hunches and intuitions is based on solid historical data?
There may be, courtesy of a famous study authored by Malcolm Baker of Harvard Business School and Jeffrey Wurgler of New York University. They constructed an index of investor speculation and irrational exuberance that, in backtesting, was highly correlated with bubbles such as the 1929 stock market crash and the bursting of the Internet bubble in early 2000.
In an email, Baker said that he and his co-author don’t have an up-to-date reading of their index. But below is a summary of the current status of the four major components of that index.
Equity share in new issues
This refers to the extent to which corporations are raising new capital in the equity market instead of the bond market. Exuberance is at a high level when this share is high.
That’s alarming, since this share has been growing markedly. Consider the accompanying chart, which plots equity issuance as a percent of GDP (courtesy of data from Goldman Sachs and GMO). Though this isn’t precisely the same ratio as used by Baker and Wurgler, it is related. Baker said the chart is “an amazing picture.”
To be sure, Baker continued, the recent equity share has probably been inflated by SPACs, which can be thought of as future IPOs since they in the not-too-distant future need to deploy the capital that they have raised. So in that sense SPACs might be considered “anticipated investor sentiment” rather than current sentiment. “That doesn’t diminish the conclusion,” however, he added.
New issue market
Two more of the Baker & Wurgler index’s components have to do with the new issue market: The sheer number of IPOs that are coming to market, as well as their average first-day return. The current message in both cases is nearly as alarming as the equity share.
In fact, Jay Ritter, a finance professor at the University of Florida and keeper of the most comprehensive historical database of IPOs, tells me that both the number of IPOs and their first-day returns have been higher recently than at any time since the top of the Internet bubble.
For example, Ritter calculates that there were 104 U.S.-based IPOs during the first four months of this year. That’s the highest for any other four-month period since late 1999, when the comparable four-month total was 199.
As for their average first-day return, it hit 84.7% for IPOs that came to market in December of last year. That was the highest monthly average since March 2000, the month of the Internet bubble’s top—when the comparable percentage was 85.7%, according to Ritter’s data.
This is the valuation differential between speculative newer firms (as indicated by whether or not they pay a dividend) and the more established dividend payers. When exuberance is high, Baker and Wurgler found, non-dividend-payers have higher ratios than payers.
That is very much the case today. Currently among issues within the S&P 500
the stocks that pay no dividends have an average price-to-book ratio that is 1.6 times higher than the average among dividend payers.
The bottom line? These various sentiment measures are painting a picture of a very vulnerable market. Given their historical correlation with past periods of speculation and irrational exuberance, it behooves us to pay close attention.
Another reason to pay attention is that these measures have only recently begun to paint this alarming picture. Two years ago, for example, at a time when many Chicken Littles had long been declaring that a bubble was about to burst, the Baker Wurgler index was, if anything, suggesting just the opposite, as I reported at the time.
It was right then. Will it be right again?