With each passing week I get asked more and more if we are in a stock market bubble. Since there is no one set definition, that is not the easiest question to answer. But if comparisons to the late 1990’s are the closest comp (the only bubble in stocks I have seen firsthand), it is hard to argue against the notion that trading action in the last year or so looks and feels like that period, though it might be narrower in scope.
In the large cap space, you have real businesses that are simply trading at sky-high prices, much like AOL, Cisco, and Dell 20+ years ago. Tesla is the easiest example, as they entered the S&P 500 as the 6th most valuable component of the index, which is just bizarre. Rather than topping out at 20-30x sales in they 1990’s, there are plenty of large cap tech firms now fetching 40-80x sales. Really tough to model the financials to map onto those kinds of expectations.
The small cap action is even worse, with Robinhood traders flipping penny stocks and bankrupt companies like it’s a video game, not a financial market. The latest example is related to Tesla indirectly; a penny stock called Signal Advance, Inc (SIGL). Elon Musk tweeted out a cryptic message “use signal” (referencing a messaging platform) and somehow people took that as an endorsement of this company, which is not related in any way. This was on Thursday 1/7 and SIGL stock surged from 60 cents to $5.76 per share.
Okay, so some people were just trying to be quick on the draw and make some money, fine. But then Friday’s trading session comes around and SIGL stock trades as high at $10 before closing around $7. That is not what is supposed to happen in a rational market. If SIGL was 70 cents two days prior, and it has been confirmed that literally nothing has changed with the company, the stock should go back down. But it didn’t.
Okay, okay, but surely when Monday rolls around and more people understand what is going on after reading about it over the weekend, the stock will drop, right? Not in a bubble. On Monday, SIGL shares rose to nearly $71 per share before closing at $38.70 each, up 438% on the day.
This is what a bubble looks like. Stocks don’t trade based on any fundamentals, but rather on near-term demand. Amateur “investors” are day trading these names on their phones, not using any kind of analysis or valuation, but rather just based on the notion that a stock might keep going up, so why not buy it? If SIGL can go from 70 cents to $7 in two days, when why not to $70 the day after? It’s gambling and the fact that you can trade commission-free on your phone only makes it easier for the silliness to continue.
So what can we expect to happen? Well, typically these traders just move on to the next stock after the last one stops going up, which will cause the price to be more rational. We have seen it with cryptocurrency stocks and marijuana stocks and now the hot sectors are things like electric vehicles (Blink Charging shares going from $1.25 to over $50 over the last 12 months) with Tesla’s meteoric rise. And obviously we can add bitcoin to the list, which is having its second insane surge in recent years.
How does it end? Well, market corrections typically do the trick. All of the day traders were wiped out in 2000 after the dot-com bubble burst because there was no way to make money anymore. Free app-based trading is here to stay, unfortunately, but once these penny stocks stop going up, traders will move on to something else and the marketplace will self-correct. There are plenty of examples of these huge stock price increases, but for those companies without the sales and profits to back up the valuations, there are few examples of the values holding for the long term. A few days, weeks, or months maybe, but rarely a few years. The majority of people who try and rise these things up will wind up selling at a loss. After a while, they stop trying.
Yes, it will end. No, it’s not healthy. And no, as a value-oriented investor I do not own money-losing penny stocks or software companies trading for 50 times sales. But that’s okay. There are thousands of securities to choose from and a diversified portfolio only needs a few dozen or so. If I want to gamble with my money, I much prefer going to a card table or sportsbook at a casino, though I understand that the pandemic has hurt the appeal of such forms of entertainment. Perhaps that too has boosted the appeal of stock trading for the time being.