INSIGHTS

BUBBLE CHECKLIST UPDATE: INCREASING MORAL HAZARD

Ed Peters
|
December 8, 2021

In February, we published a stock market bubble checklist that I had developed after the tech bubble of the late 1990s. The original publication said that while many of the items were checked off, we weren’t quite there yet. Two checklist items remained. The first was box #2, an innovation that leads people to believe that the future will not be like the past – basically, a “this time things are different” mindset. In October, we said that this box had now been checked. Cryptocurrencies, which were originally an example of a mini-bubble, had grown into a new type of speculative vehicle where rationalizations had run rampant to justify significant capital allocations. What remained was only the fifth and final box: moral hazard.

Moral hazard appears when investors believe that the market will always rebound because the innovation that has changed everything (box#2) justifies high valuations. Any drop in the market is a buying opportunity. The New York Times recently reported a disturbing trend: Each pullback in the US stock market this year has not only resulted in a rebound to new highs, but the duration of the drawdowns has become progressively shorter.1 Last week, global stock markets dropped as the Fed and other central banks began signaling that the era of low interest rates (box #1) was drawing to a close. This more hawkish language came as a new, possibly more contagious variant of COVID-19, Omicron, emerged, while parts of the global economy moved to close due to the already widespread Delta variant. But mere days after the drawdown, the markets have rebounded and are now closing in on their old highs.

This increased “buy on the dips” mentality coupled with shorter drawdowns leads us to worry that moral hazard is becoming more problematic. If investors begin to feel invulnerable, then moral hazard will be here and the bubble can be considered fully inflated. We may not be quite there yet, but we are definitely too close for comfort.

Endnotes
1Russell K and Hadi M. “Stocks Rebound Faster from each Covid Drop,” The New York Times, Dec. 7, 2021.

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