Following a surprisingly decent year for stock markets in 2020, some analysts and commentators are expecting a large-scale correction to occur later this year.
Fiscal and monetary stimulus have been able to support the global economy during the difficult months of lockdown, but as the vaccination programme presses on and society begins to open up, many have raised concerns of what this will this do to a stock market exhibiting signs of overvaluation.
Giles Coghlan, chief currency analyst at HYCM, outlined the overvaluation of particular shares and identifies the possible catalysts for causing a stock bubble to burst in 2021.
“Fears of a stock market bubble have been made more complicated by the sheer volatility on display in both the US and the UK,” he said.
“Bullish runs are being quickly followed by sudden price drops, particularly in the US.”
Since the turn of the year, the S&P 500 index has made 1.73 per cent, suffering sharp losses at the end of January and start of March.
Performance of the S&P 500 in 2021
Source: FE Analytics
Coghlan explained that this is perhaps less to do with industries and more do with investor sentiment towards individual companies.
He gave Tesla as a clear example of extreme investor behaviour. Between October 2019 and January 2021, the electric car maker’s share price rose from under $100 to over $750.
“The price has been driven up primarily by demand, as oppose to other market fundamentals,” he said. “The price is now looking to drop below $500 in the coming weeks, which many believe reflects a price correction, rather than a crash.
“As we saw with GameStop earlier in the year, retail investors are becoming more bullish and targeting short stocks in a bid to trigger short or gamma squeezes.
“In my mind, this is no doubt contributing to the volatility at the moment.”
Easy access and low fees on platforms like Robinhood have made it easier for investors to drive up share prices over the last year.
“Day trading, and even swing trading, has become more accessible and can explain why the markets are so volatile at the moment,” said Coghlan.
He expressed concern that the new wave of retail investor is not fully aware of the financial markets and how to develop an investment strategy.
“That’s why it’s important that investors and traders do deep due diligence, have clear investment objectives in mind and establish a risk/return ratio.”
In the event of a market correction, he said there is a justifiable concern that these investors might panic in an attempt to cut their losses.
“That’s why retail investors need to be disciplined,” Coghlan added. “The tools might be there for trading, but there is no point using them until one has developed a proper understanding of the market fundamentals and how an investment strategy can be fashioned around them.”
Will there be crash this year and how damaging will it be?
If veteran investor Jeremy Grantham is to be believed, then the US and possibly other developed economies are heading for a 1929-style crash that would devastate portfolios.
While previous bubbles have combined accommodative monetary and economic conditions, this time around the economy and the market are at polar opposites.
Large-scale stimulus packages prevented an economic collapse in March last year and will continue to prop up markets well into 2021.
However, Coghlan outlined that the impact of a crash could be limited if several factors converge.
The first is the ability for central banks to implement negative interest rates, something which the Bank of England has said to prepare for in the near future.
However, for the time being the Bank of England’s Monetary Policy Committee has kept rates at 0.1 per cent, falling from 0.75 per cent since the start of the Covid-19 crisis.
“While at the moment, the chances of negative interest rates look unlikely - they could quickly be deployed if markets start falling,” he said.
“Secondly, the sheer monetary value of fiscal stimulus packages being deployed by governments around the world demonstrates the willingness of governments to provide the necessary support to overcome these kind of short-term challenges.”
Furthermore, Coghlan said that it was normal for markets to experience a level of pullback and the periods of peaks and troughs allow markets to grow.
Annual returns and intra-year declines of the S&P 500 over 20yrs
Source: HYCM
“As long as we keep this at the back of our minds, investors will always be prepared for any sudden market correction,” he said.
While calling the date of a bubble bursting is near-on-impossible, there are certain warning signs and events that can precipitate a crash.
“It’s difficult to tell given that there are some uncertainties in the air at the moment,” he said. “I believe that if the US and the UK are able to transition out of lockdown as planned and respective economies are able to recover, the chances of a severe crash are greatly reduced.
“Should this not be the case, the conditions are then right for a correction.”
Coghlan said that ‘sell in May and go away’”, the well-known saying, can prove to be sage advice for investors looking to reduce their exposure to equities this year.
“The basic premise is that you want to own equities from the end of October through to the end of April, before selling off in May,” he said.
He went on to add that historical data over the last 70 years showed that the S&P 500 generally sticks to this rule with usually only modest rises seen during the summer months (around 0.38 per cent on average).
“Could this also trigger a crash?” he asked. “We will have to wait and see.
“For now, I urge investors to tread carefully and as a general rule of thumb, always plan your investment portfolio taking to account all possible future scenarios, the good and the bad.”