Is the stock market in a bubble?

The past year or so has been one of most exciting times ever seen in capital markets. During the advent of the coronavirus pandemic, there was a feeling amongst market participants that the world was going to come to a grinding halt. And those feelings weren’t necessarily wrong. The stock market endured its fastest ever bear market in history, with global indexes retracting almost 40%. Lockdowns were introduced as a defence mechanism to curb the spread of the coronavirus, bringing the global economy to its knees.

The paranoia in the markets didn’t last long with markets sharply rebounding in April to bounce off the lows recorded in March. With all the hysteria in the capital markets, retail investors began to climb in, taking advantage of the drawdowns experienced in March. Retail investors have since gained increased prominence in the markets and their success in 2020 may well be their downfall in 2021. Or are we seeing a paradigm shift?

Markets have continued to soar, with indexes gaining over 70% since the lows recorded almost a year ago. It’s been the largest stock market reversal ever seen. Many traditionalists are calling the market a ‘bubble’, with a seemingly large disconnect between the economy and the stock market. First things first – the economy has never been a proxy to the stock market.

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These traditionalists include some of Wall Streets finest – Warren Buffet and Charlie Munger. For those that might not know Charlie, he’s Buffet’s sidekick. Warren and Charlie are very old-fashioned. They use what’s known as a ‘bottom up’ approach to value companies, something that’s worked exceptionally well for them over their illustrious careers.

By extrapolating the future earnings of a company and discounting it to its present value, Warren and Charlie manage to approximate the value of a company’s shares. The traditionalist has to estimate inputs such as growth and discount rates. Both growth and discount rates are extremely sensitive to small changes in assumption, which affect’s the overall outcome – the net present value of the company. Sounds tricky, right?

Who wants to be Warren and Charlie, when they can be a retail investor. Retail investors are a lot more simple in their methodology. Free cash flows and price to earnings multiples are curse words to the retail investor. However, the entire market is built on speculation. The value of a company is inherently subjective. Let’s look at Tesla as an example – all valuation metrics will tell you the company is overvalued. However, the company trades at a market capitalisation of over $800bn. Similarly, with regards to the reddit-fuelled GameStop rally, the ‘bottom-up’ valuation technique doesn’t tell us how the share managed to reach an intra-day high of $483. The discounted free cash model gave a share price of $15, how can this be right? Speculation.

Read also: Bitcoin rallies as Tesla invests $1.5bn; will accept crypto for cars

Who’s to say that Bitcoin doesn’t replace gold as the new store of value? The only reason market participants have seen gold as a ‘safe haven’ asset and a store of value against risks such as inflation and economic upheaval is because that’s what history tells us. Valuation will always be important, however, even traditionalists would be ignorant to think we are not going through a paradigm shift in the capital markets.

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