Ray Dalio, the billionaire founder of the hedge fund largest in the world, it is known for many things, but above all for its "bubble indicator", its masterpiece. It is based on six questions that help establish whether we are in an unsustainably high price environment, and it sounded the alarm on US stocks early last year. So let's check again and see if that bubble is still intact...
What are Ray Dalio's six questions?❓
1) How high are share prices relative to traditional fundamental valuation measures such as P/E or earnings per share?
Right now, this measurement is roughly an average. After the recent drop in US stocks, it is currently at a 50% ratio over the past 110 years.
2) Are prices discounting unsustainable conditions? ️
This involves assessing the levels of corporate earnings growth required for stocks to outperform bonds. This measure has risen over the past two years as bond yields have grown, raising the hurdle for stock returns and is now at 60% for U.S. stocks. That is, discounted earnings growth in stocks is a bit high, and this is even more notable in the US software sector.
3) How many new investors have entered the market lately?
A flood of new entrants, especially smaller investors attracted by rapidly rising prices, is often eye-opening. This measure soared above 90% in 2020 after an influx of retail investors into much-hyped stocks. But more recently, retail activity in markets has regressed to pre-Covid averages.
4) Overall, how positive is investor sentiment?
If you're too optimistic, many investors may have already invested everything they have, meaning they are more likely to be sellers than buyers. That is not the case now. Sentiment in the market is strongly negative, reaching levels we saw during the deepest depths of the dotcom bubble collapse.
5) Are investments financed with high leverage?
Buyers who rely heavily on margin (borrowed money) or leveraged products like options are more vulnerable to forced selling in a downturn. As things stand, the US market is doing well overall, with this measure sitting at 50%.
6) Are companies investing in their future?
Business spending on things like equipment and factories can reveal whether stock market optimism has infected the real economy, creating potentially unrealistic (and costly) expectations for demand growth. This indicator is currently at 40%, or slightly below average, perhaps affected by ongoing supply chain issues.
So, what does the bubble indicator show?
The chart below shows the composite bubble measure applied to US stocks over the past 110 years and expressed as percentages. In a nutshell, the higher the reading, the more the indicator implies a stock market bubble. US stocks are currently down 40%. That suggests we are no longer in a bubble.
The US stock bubble indicator is in the 40th percentile. Source: Bridgewater Associates
Now that the bubble has burst, is it time to get back in?
Without the help of a crystal ball, it is difficult to give a definitive answer to this question, but the short-term answer may be: NO. Let's see... while the market reversal has been significant, the discount to future earnings growth is still somewhat high compared to history, especially when a recession is believed to be looming. Additionally, US stocks still look a bit overvalued by some measures.
History suggests that once the burst begins, bubbles often overcorrect to the downside—that is, selling more than the fundamentals would suggest—rather than simply settling at more “normal” prices. And this over-correction can be a long process because the bubbles often take a while to fully relax. Previously, two years in the case of the 1929 bubble and one year in the case of the dotcom bubble of the late 90s. Put another way, the fact that stocks are no longer at the end of a bubble It doesn't mean they are a good buy now. History suggests there are more downsides to come. History does not repeat itself, but it often rhymes... Mark Twain