Financial History 139 (Fall 2021) - Page 13

In the 1920s , a few legendary investors managed to do exactly that . Among them were Roger Babson , founder of the eponymously named college ; John Jakob Raskob , builder of the Empire State Building ; and Joseph Kennedy , first chairman of the SEC and father of President John F . Kennedy . Each of these investors made — or added to — their fortunes by knowing when to say “ enough .”
There is a broad suspicion the US equities market is now experiencing a bubble . It took only a few short months in 2020 for investors to pivot from distress to euphoria as stock prices soared above pre-pandemic levels . The price-earnings ( P / E ) 2 ratio provides additional evidence that shares might be overvalued in today ’ s market .
The historical average P / E ratio for the S & P 500 is 15 ×. Today ’ s ratio , using data from the last 12 months , is 30 ×. It has only been this high twice in history — during the dot-com bubble in the late ’ 90s , when it reached similar levels , and the 2008 financial crisis when it peaked at 70 ×.
One could also calculate the ratio based on estimates of future earnings per share over the next 12 months , to account for the negative effects of the pandemic lockdowns on earnings . In doing so , one would find the P / E ratio to be 20 ×, still above the historical average . Regardless of how the numbers are crunched , the conclusion is clear — we are in a bubble .
But the question remains , how close is the bubble to bursting ?
After the 1929 crash , Galbraith identified four factors that support financial bubbles . Imagine a four-legged stool — when all legs are intact , the market is solid as a rock . As legs begin to break , the stool becomes increasingly perilous to sit on . In a similar fashion , when a critical mass of these indicators are disrupted , the bubble bursts .
The following four factors , in various orders and extremes , have successfully explained the 1929 crash , as well as subsequent crashes .
1 . Laissez-Faire Government
Financial bubbles require regulatory and tax policies that are friendly to business . This has little to do with politics , and everything to do with the impact of public policy on earnings . In the 1920s , the beginnings of congressional tariff discussions — that eventually became the Smoot Hawley Tariff Act — were seen by market professionals
Economist John Kenneth Galbraith , who famously said of those attempting to predict future stock market performance , “ There are two kinds of forecasters : those who don ’ t know , and those who don ’ t know they don ’ t know .”
as a signal that laissez-faire was coming to an end . Before the 1987 crash , mere congressional talk of eliminating the ability to deduct interest on high-yield bonds signaled to the markets that the Reagan era of hands-off authority was ending and contributed to the bubble bursting .
The Biden administration has played an aggressive role in attempting to mitigate the aftermath of the pandemic with passage of the American Rescue Plan , along with publishing 52 executive orders in his first weeks in office and proposing significant increases on individual and corporate taxes .
These interventions , along with the appointment of Gary Gensler as SEC Chairman — who advised on the Sarbanes- Oxley Act to address the excesses of the dot-com bubble — indicate the climate will not be as friendly toward business as it had been under prior administrations . This leg of the stool is cracked but not fractured .
President Biden has thus far not followed the preferences of the most extreme elements of his party . For example , despite Senator Bernie Sanders , et al advocating for a $ 5 trillion infrastructure plan , President Biden has agreed to the $ 1 trillion infrastructure package approved by the Senate . Were the President to succumb to these extreme elements , the crack in this leg of the stool would become a compound fracture .
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2 . Leverage
Is the stock price being supported by large amounts of borrowed money ? Financial bubbles are inflated when investors borrow money to buy more shares than they would have been able to afford otherwise . Borrowed money accelerates volatility , which is great in a bull market when it helps push stock prices upward . However , the reverse can be catastrophic .
Between 1926 and 1929 , the amount of money borrowed to buy stock in America , or “ margin debt ,” doubled . In May 2021 , margin debt reached an all-time high of $ 861.63 billion — more than double the margin debt of $ 328 billion seen at the height of the dot-com bubble and the $ 420 billion of margin debt seen at the housing bubble peak . The amount borrowed is growing by 40 % with each passing year . Despite market levels rising along with it , that is a significant level of borrowed money supporting the market .
A survey of consumers conducted from March 30 to April 6 , 2021 , found that 80 % of Gen Z and 60 % of millennial investors borrowed money to invest .
The rag-tag renegades of Reddit retail investors exposed yet another risk of excessive leverage during the GameStop saga : inadequately capitalized intermediaries . When the proletariat was prohibited from buying more GameStop stock by their broker Robinhood , it was not because the app was colluding with Wall Street pros . It was because the regulators and clearinghouses were demanding $ 3 billion in more capital — and quickly — to compensate for their increased exposure to GameStop ’ s price collapsing .
Robinhood is by far the largest online broker . At the start of the year , it was being downloaded more than twice as much as Fidelity , TD Ameritrade , E-Trade and Schwab combined . Yet , at the same time , Robinhood was scrambling to find billions of dollars to meet regulatory requirements to stay in business . Not only were individual investors highly leveraged , but the infrastructure was at risk because the largest online participant was also overleveraged . Subsequently , Robinhood recognized its need for more efficient access to capital by going public via an IPO in July 2021 .
What can be done to keep leverage at bay ? The primary tool available to regulators to control the buying of stocks with
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