[Viewpoint] High Probability of a U.S. Stock Market Bubble Burst

Kim Young-ik, Adjunct Professor at Sogang University Graduate School of Economics

Major U.S. stock indices have risen more than sixfold from March 2009 to the end of last year, amid intensifying debates about a possible bubble. Is it really a bubble? Will the bubble burst?

There is no clear standard to judge a bubble in the stock market because each investor has different price expectations. However, Ray Dalio, who leads the world's largest hedge fund Bridgewater, presented seven criteria to determine whether there is a bubble: 1) Is the price high compared to traditional measures? 2) Is the price overestimating future earnings? 3) Are investors using high leverage to purchase assets? 4) Are investors or companies excessively optimistic about the future? 5) Is there an increase in new market participants? 6) Is there a prevailing optimistic atmosphere in the market? 7) Are there concerns that monetary policy tightening risks could burst the bubble?

Let's assess the bubble using key indicators. First is the so-called 'Buffett Indicator,' which is the stock market capitalization divided by nominal Gross Domestic Product (GDP). If we define market capitalization as the total value of stocks held by all economic agents in the U.S., the Buffett Indicator reached an all-time high of 331% in Q2 2021 (323% in Q3). This is not only much higher than the post-2000 average of 180% but also significantly exceeds the 210% level seen during the information technology bubble in the early 2000s. Another traditional measure is the Price-to-Earnings Ratio (PER). The Shiller PER of the S&P 500, a representative U.S. stock index, stood at 39 in January 2022, more than twice the long-term average of 17. U.S. investors borrowing to buy stocks may also signal a bubble. Margin debt surpassed $900 billion at the end of October last year, marking a record high.

Due to rising stock prices, the proportion of stocks in U.S. household financial assets reached 53% as of the end of September last year, the highest since 1968. The stock proportion was 48% in March 2000 and again in June 2007, both times followed by sharp market declines. Based on these indicators, it seems undeniable that the U.S. stock market has entered bubble territory.

So, where can we find factors that might cause the bubble to burst? The first reason would be a shift in the Federal Reserve's (Fed) monetary policy. To overcome the 2008 financial crisis and the 2020 COVID-19 economic crisis, the Fed maintained ultra-low interest rates and printed money on a large scale. This helped the economy recover but signs of inflation have emerged. In particular, consumer prices rose 6.8% year-on-year in November last year, the highest since June 1982. Accordingly, the Fed is expected to end quantitative easing by March and raise interest rates. Depending on economic conditions, quantitative tightening may also be implemented within this year.

Even if interest rates rise, stock prices could continue to increase if economic expansion persists and corporate earnings grow. However, as the year progresses, the economy is likely to slow down and corporate earnings growth may decline. The U.S. Leading Economic Index, compiled by the Organization for Economic Cooperation and Development (OECD), peaked in June 2021 and has fallen for six consecutive months through November. This suggests that the economic slowdown could be brought forward to Q2 this year. Liquidity and economic conditions that drove stock price increases are moving in the opposite direction. During such times, stock prices could plunge, quickly reversing the success stories of 'Seohak Gaemi' (Korean investors investing in U.S. stocks).

This content was produced with the assistance of AI translation services.