Written by Norman Isaac Mwambazi

Three indicators that predict whether the stock market is in a bubble

In the previous two weeks, we have seen cryptocurrencies dropping rapidly from record highs to alarming lows. Most investors were …

In the previous two weeks, we have seen cryptocurrencies dropping rapidly from record highs to alarming lows. Most investors were caught off-guard and I am quite sure the way they reacted to seeing red lights in their portfolios would be different if they knew when this kind of plummet would happen.

The same thing could happen in the stock market and we would see an even bigger irrational reaction. With that being said, investors would be more than glad to know whether the stock market is in a bubble and thanks to a famous study authored by Malcolm Baker of Harvard Business School and Jeffrey Wurgler of New York University, there could be indicators.

Baker and Wurgler constructed an index of investor speculation and irrational exuberance that, in backtesting, was highly correlated with bubbles such as the 1929 stock market crash and the bursting of the Internet bubble in early 2000.

In an email, Baker said that he and Wurgler do not have an up-to-date reading of their index. Below is a summary of the current status of the three major components of that index.

Equity share in new issues

This refers to the extent to which corporations are raising new capital in the equity market instead of the bond market. Exuberance is at a high level when this share is high. That is alarming since this share has been growing markedly.

Consider the accompanying chart, which plots equity issuance as a per cent of GDP (courtesy of data from Goldman Sachs and GMO). Though this is not precisely the same ratio as used by Baker and Wurgler, it is related. Baker said the chart is “an amazing picture.”

Three indicators that predict whether the stock market is in a bubble

To be sure, Baker continued, the recent equity share has probably been inflated by SPACs, which can be thought of as future Initial Public Offerings (IPOs) since they need to deploy the capital that they have raised in the near future.

In that sense, SPACs might be considered “anticipated investor sentiment” rather than current sentiment. “That doesn’t diminish the conclusion,” however, he added.

New issue market

Two more of the Baker and Wurgler index’s components have to do with the new issue market: The sheer number of IPOs that are coming to market, as well as their average first-day return. The current message in both cases is nearly as alarming as the equity share.

Jay Ritter, a finance professor at the University of Florida and keeper of the most comprehensive historical database of IPOs, said that both the number of IPOs and their first-day returns have been higher recently than at any time since the top of the Internet bubble.

Ritter calculates that there were 104 US-based IPOs during the first four months of this year. That is the highest for any other four-month period since late 1999 when the comparable four-month total was 199.

As for their average first-day return, it hit 84.7% for IPOs that came to market in December of last year. That was the highest monthly average since March 2000; the month of the Internet bubble’s top – when the comparable percentage was 85.7%, according to Ritter’s data.

Dividend premium

This is the valuation differential between speculative newer firms (as indicated by whether or not they pay a dividend) and the more established dividend payers. When exuberance is high, Baker and Wurgler found, non-dividend-payers have higher ratios than payers.

That is very much the case today. Currently, among issues within the benchmark S&P 500, the stocks that pay no dividends have an average price-to-book ratio that is 1.6 times higher than the average among dividend payers.

The bottom line? These various sentiment measures are painting a picture of a very vulnerable market. Given their historical correlation with past periods of speculation and irrational exuberance, it befits us to pay close attention.

Another reason to pay attention is that these measures have only recently begun to paint this alarming picture. Two years ago, for example, at a time when many Chicken Littles had long been declaring that a bubble was about to burst, the Baker Wurgler index was, if anything, suggesting just the opposite, as I reported at the time.