In today’s Exponential Investor:

  • What the “fear gauge” is showing us
  • A reckoning on the horizon?
  • Easier than falling in love

The Nasdaq Composite’s record high yesterday was the seventh record high the index has achieved this year.

Those milestones come a month after consumer confidence returned to pre-pandemic levels in the UK.

You can see the complacency outside of new market highs and consumer surveys.

Take what the so-called “fear gauge” – the Chicago Board of Option Exchange’s Volatility Index – is showing over the last six months:

Source: Yahoo Finance

You can see plenty of fits and starts along the way… but overall, fear has declined over the last six months, as new (irrational?) optimism takes hold.

Now, there’s plenty of good news to justify this lull. In the UK, online job adverts hit more than double their pre-pandemic levels of February 2020. The economy showed 2.1% GDP growth in March, and City economists upgraded their forecasts. US consumer confidence is at a 14-month high in April.

It’s easy to find rosy economic news and reasons for bullishness everywhere you look.

And that’s the problem… Today I’m re-upping a story that originally appeared in Southbank Investment Daily in February, after a phone call I had that left me feeling apprehensive about the market euphoria around us. In it, you’ll find why moments like these are times markets can be at their most dangerous.

The Doug Indicator

Last Friday a friend asked if his father could chat with me about day trading. The 58-year-old man, who we’ll call Doug, wants to open a day trading account for the first time in his life.

I told him I’d be happy to talk, though I told him I wasn’t going to recommend any stocks. But I had an uneasy feeling after agreeing to speak to Doug.

You see, Doug is the definition of a latecomer investor. Like most people, he doesn’t think about the stock market every day. So when people like him are enticed into rallies, it’s usually a sign the crash isn’t far away.

Two days ago, I got Doug’s call.

“How the hell are you?” Doug asked me. I gave him the rundown – riding out the pandemic in Baltimore, then heading back to London – and then he got down to brass tacks.

He told me he was bored from being semi-retired. He had a sizeable amount of cash sitting in a bank account garnering 0.15% interest. And since last March, he had heard stories about friends’ exploits in the market.

“Well, Doug,” I said. “You gotta remember, when you hear these stories, they’re following the No. 1 rule of market chatter at cocktail parties – only talk about your winners. I’m not sure things have been quite as rosy as they say.”

“But yeah, there’s no denying the markets and cryptos have gone up a lot lately.”

I told him that times like these are when the market is actually at its most dangerous. I told him that by some measures, the market is more expensive and toppish than it has been since the dotcom collapse. And I told him that the fact that people who don’t live and breathe markets and tech revolutions are thinking of getting in might means the mania is nearing its peak.

“So I should pull out my money before a crash?” he asked.

“I can’t say that either. See, just because markets are overpriced doesn’t mean there will be a crash tomorrow, or in a month or even a year from now. Markets could roar another 20 or 30%.”

“But what do you think will happen?”

“I just don’t know. Nobody does. If you ever hear someone say they know what the market will do next, run away. Not even Warren Buffett makes these predictions. The only thing I can really say definitively is, if you’re going to day trade in today’s markets, it has to be money you can afford to lose.”

Eventually, Doug pinned me down. “Okay, you can’t say for sure. But if you had to guess? What’s your hunch?”

I told Doug my hunch – that trillions of dollars in ongoing and future stimulus from governments and central bankers would power markets for at least a few more months. From US President Joe Biden pushing for $1.9 trillion in stimulus, to the Bank of England conjuring £150 billion out of thin air, to the EU’s $2.2 trillion stimulus, to – most significantly of all – a likely relief rally when Covid-19 is vanquished – all the near-term catalysts seem to point to more upside than downside.

But eventually, there would be a reckoning – maybe not tomorrow, or next month, but probably within a few years in my view. Exactly how soon was the only real question.

For a historical parallel, I brought up the year 1997, when valuations were clearly stretched but the Nasdaq still had another 200% run in store while already-famous companies like Qualcomm were set to soar 1,500%. (I didn’t recall the exact numbers, but researched them for this story.)

“Some people in 1997 were saying what I’m saying today,” I said. “And by early 2000, they seemed pretty stupid, with everyone who ignored their advice getting rich. So, is this moment like 1997, or is it more like spring 2000, right before the dotcom collapse? That’s the question.”

When we ended the call, I sensed Doug was a little disappointed that I couldn’t be more emphatic. And I got the sense he’s less likely to start day trading after talking to me.

I’ll never know if I did him a favour or not – not even in retrospect, since anyone can outwit a bear market, or get burned in bullish times.

But while our call left him a little disillusioned, my guess is that a little disillusionment is exactly what most investors need right now.

As for me, the call also made me more cautious. It’s just one anecdote, but when latecomers begin piling into markets, the end may well be nigh.

And markets are expensive today. That’s just a fact. And not just expensive, but historically so – last month the S&P 500 hit a cyclically adjusted price-to-earnings (CAPE) ratio of 34. That makes it the second-most expensive it’s been in history.

The only time it’s been more expensive is, of course, the height of the dotcom bubble.

What about the FTSE? Last December its average CAPE ratio was just 17.55, making it about half as expensive as US stocks.

From that measure, investors with more exposure to British equities have less to fear from a bubble. But with talk of negative interest rates gaining momentum at the Bank of England, a financials-heavy index could be vulnerable for a different reason in the months ahead.

Of course, while the warning signs abound, I’m the first to admit it may not feel like these times are dangerous.

Easier than falling in love

Speaking of the 1990s, I remember a commercial from TD Ameritrade designed to galvanise retail investors.

In it, the office geek exhorts his boss to make his very first trade, 100 shares of Best Buy. “It’s easier than falling in love!”

When his boss protests he doesn’t know enough about the stock to invest, his employee brushes it off by pointing to all the technical analysis TD Ameritrade has provided right there on the screen. Now fully informed, his boss pulls the trigger.

You can watch the commercial here. It perfectly encapsulates the era.

Out of curiosity, I looked up the fate of Best Buy stock shortly after this commercial ran in 1999. After soaring briefly in 2000, it crashed to barely half its 1999 levels.

Knowing what we know now, that ad almost feels like a parody of the times. But the euphoria captured in that commercial was very real for the age.

Then again, Best Buy today trades at more than double its June 1999 levels. So while Buffett’s more famous quote about being greedy when others are fearful, and fearful when others are greedy gets the most attention at times like this, it’s appropriate to remember another observation of his: that the stock market is a device designed to transfer money from the impatient to the patient.


William Dahl
Editor, Southbank Investment Research