Gold: Indicator of the World’s
Executive Summary:
Investors must distinguish between market bubbles and regular market cycles. Market cycles are determined by fundamental economic factors and are an integral aspect of market dynamics. In contrast, a market bubble is characterized by unsustainable price growth that is not supported by fundamental indicators. When a bubble bursts, prices fall, leading to significant and often irreversible losses for investors.
If a stock price is high and likely to fall, it does not necessarily mean the stock is in a bubble. Instead, it could simply be going through the typical stages of a market cycle.
Our current analysis of the U.S. stock market shows that, while there may be pockets of overvaluation, the market as a whole does not exhibit the characteristics of a bubble.
The term “asset bubble” conjures images of rapid wealth accumulation, sparking mania around an asset, followed by significant financial losses when the bubble bursts. This phenomenon has fascinated investors and economists for decades. Financial experts often use this term in various contexts—”stock market bubble,” “AI bubble,” “real estate bubble,” “tuition bubble”—to the extent that it seems everything is labeled a “bubble.” But what exactly is a market bubble, and how can investors recognize it?
In this article, we will delve into what constitutes a market bubble and examine the current market conditions to determine if we are in one. I argue that the term “bubble” is often misused, and a better analogy might be a balloon. Investors need to recognize that the economic system can manage abundance until it reaches extreme levels and that markets move cyclically rather than perpetually forming bubbles. While there may be pockets of abundance in some parts of the market today, overall, I believe we are not in a stock market bubble.
Bubble Definition
The concept of a market bubble is relatively new, and this term has become widely used only in recent decades. Robert Shiller, an economist and Nobel laureate, has been involved in defining and diagnosing bubbles. In his book “Irrational Exuberance,” Shiller compares bubble detection to diagnosing a mental illness, using a checklist of symptoms. Below are several examples:
- Sharp price increases: Strong short-term results.
- Overvaluation: Prices significantly exceed their historical norms or fundamental value.
- Popular stories justifying price action: Compelling stories, such as “new era” thinking.
- Tales of substantial profits: Promises of quick enrichment.
- Envy and regret among those who did not invest: Fear of missing out (FOMO).
- Media frenzy: Increased attention, constant reminders about investments.
While this checklist provides a useful framework, it is not foolproof. Recognizing bubbles and acting in real-time is very challenging. For example, Alan Greenspan, former Chairman of the Federal Reserve, emphasized in his famous 1996 speech that asset prices were overvalued compared to fundamental values, warning that the stock market was overpriced. However, over the next couple of years, the stock market doubled. Even if the market is considered to be in bubble territory, it does not mean it will burst soon or that prices will stop rising.
Furthermore, assets can exhibit symptoms and not be actual bubbles. This is because bubbles need to be distinguished from normal market cycles, which are natural fluctuations characterized by periods of expansion and contraction. Although markets often exaggerate these movements, cycles are driven by fundamental economic factors and are an integral aspect of market dynamics. In contrast, a bubble is characterized by unsustainable price growth not supported by fundamental indicators. When the bubble bursts, prices fall, leading to significant, often permanent, losses for investors.
Think of a bubble as investments where expected returns do not increase significantly after price declines because the underlying investment premise has collapsed. This was evident during the dot-com bubble; despite some stocks falling by 90%, future earnings did not increase enough to facilitate recovery.
Understanding whether an asset is in a bubble or part of a cycle is important for making investment decisions. Bubbles should be avoided due to the risk of widespread irreversible capital loss. On the other hand, cycles are part of normal market behavior and require patience and humility to achieve long-term profits. If an asset’s price seems excessively high and likely to fall, it may not be a bubble but simply typical market behavior. Excesses will correct, recover, and life will go on. Thus, true market bubbles are rarer than people think if they only follow financial news.
Bubbles imply a fragile system in equilibrium, where any minor external factor can cause a sudden and irreversible explosion. In contrast, the metaphor of a hot air balloon acknowledges that markets can become overly inflated but also have the ability to deflate and stabilize. The system is dynamic, much like how markets move in cycles.
This analogy also emphasizes that the economic system can withstand abundance up to a certain point. Fragility arises when an excessive amount of air (excessive investments and speculation) exerts unstable pressure on the system. It’s not external factors that cause the explosion but rather a small additional amount of air that stretches the system to its limit.
Market-Related Symptoms
The U.S. stock market has demonstrated stable dynamics: the basic S&P 500 index has increased by approximately 11% since the beginning of the year. However, such high returns are not unique to the U.S.; Japan and Europe have also experienced growth, and many markets have reached record highs.
When we examine valuations, overall indicators such as the price-to-earnings (P/E) ratio suggest that the U.S. market may be overvalued. The market seems to have priced in a lot of good news, which creates high expectations for future growth. Although this may indicate overvaluation, a real bubble is characterized by persistent and unsustainable price growth. The U.S. market has been considered expensive for several years, and the recent high returns of the market were primarily driven by income growth rather than multiple expansions.
It is important to note that high valuations in the U.S. stock market are not uniform across all sectors. In most cases, they never are. Specific sectors, such as AI stocks or technology companies, may appear sluggish, but the entire system may sustain some level of abundance. As mentioned earlier, a hot air balloon can hold a certain amount of air without bursting. Similarly, assets reaching overvaluation territory and then correcting do not necessarily indicate a bubble. This is part of normal market behavior.
Overall, market factors do not indicate the existence of a bubble in the U.S. stock market.
Psychological Symptoms
Narratives are powerful drivers of human behavior. In financial markets, stories about why this time is different, observations of neighbors getting rich, extensive media coverage, fear of missing out (FOMO), and frequent discussions about investments—even among those who don’t usually invest—all contribute to psychological pressure to play. In extreme cases, these factors can push people into significant risk-taking, such as investing savings or taking on debt, without fully considering the negative consequences.
A common approach to assessing overall market sentiment or tone is to look at the volatility index (VIX), also known as the fear gauge, which measures market expectations of short-term volatility. Other common sentiment indicators include investor confidence surveys, such as the American Association of Individual Investors (AAII) sentiment survey, as well as the put-call ratio, which compares put option volumes to call option volumes to gauge investor sentiment.
At the end of 2022, market actions were primarily perceived through the lens of changes in bond yields, Federal Reserve policy, and recession risks. Today, the focus has shifted to earnings reports, market highs, and potential rate cuts.
It seems that narratives corresponding to the checklist of bubble symptoms are absent. Media attention does not ignore the fundamental picture and does not demonstrate excessive excitement around the stock market. However, if we shift our focus to topics like artificial intelligence, we may observe a different trend. In addition to market indicators and television media, news articles can also provide insight into market sentiments. This can be achieved by assigning a sentiment score based on the frequency of “positive” or “negative” words in articles. Although this approach is not perfect, its evolution over time can provide valuable information.
Current analysis of the U.S. stock market shows that, while there may be pockets of overvaluation, overall the market does not demonstrate characteristics of a bubble. Recent results have been primarily driven by fundamental growth, and narratives are not yet a significant force driving people to take on significant risk.
What does all this have to do with Gold? At first glance, Gold can become an alternative asset in the conditions of a changing financial paradigm. If the stock market ceases to be a bubble due to a change in the bubble paradigm itself, investors may turn to other assets in search of protection from inflation and instability in the financial sphere. Gold, as a traditional alternative asset, is usually considered a safe haven in times of instability.
However, it is worth remembering that Gold does not always react unequivocally to changes in the financial system. Its price may depend on a variety of factors, including inflation, interest rates, geopolitical instability, and demand for jewelry. It is also important to remember that Gold does not generate income in the form of dividends or interest, like other assets, and its price may fluctuate depending on market demand.
Thus, while Gold may be an attractive asset for portfolio protection in times of financial market instability, investors should consider multiple factors when deciding whether to include it in their investment portfolio.
BT
