Has the Liquidity Bubble Already Started to Pop?

January 13, 2022

Source: Bloomberg Source: Bloomberg

The rally from the 2020 COVID-19-induced market decline has been incredible, with a staggering and unprecedented amount of money entering the equity markets over the past two years. According to Bank of America, the rolling 12-month equity inflows of $1.1 trillion exceeded the combined equity inflows of the past 19 years, which is simply unbelievable.      

The Federal Reserve’s (Fed) stimulus and resulting surge in money supply and liquidity spread into many unintended areas of the investment markets too. This newfound capital poured into companies of all sorts — with much of it going to high-flying growth companies that had yet to make any profits and other unproven investments.    

Historically, if you follow periods of market excess, you can identify the same characteristics in these types of euphoric conditions. New technologies, ways of investing and figureheads enter the market with enthusiasm. Ultimately, this excitement makes its way to the general public and the masses instantly become market experts.

In the 1920s, the shoeshine kids would recommend stocks. Today, we have the Island Boys pitching investments on TikTok. We are seeing different manifestations of the exact same irrational investor behavior, with signs everywhere of malinvestment (investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank).

In this round of the bubble, we have non-profitable “unicorn” initial public offerings (IPOs), special purpose acquisition companies (SPACs) and the proliferation of cryptocurrency “stablecoins” and non-fungible tokens (NFTs). As a rule of thumb, anytime you see investments with fancy acronyms, it is usually best to run in the opposite direction. These unicorns and alternative investments promising limitless growth potential without much in the way of actual sales, earnings or cash flows are fueled by an equally limitless supply of investor interest and demand.    

Now, you would never know it if you only used the broad stock market indexes as a guide, but the coming Fed policy shift (taper and rate hikes) has already left a mark across the equity markets. According to Jason Goepfert, chief research officer at Sundial Capital Research, roughly four in every 10 companies on the Nasdaq Composite Index have seen their market values cut in half from their 52-week highs, while the majority of gauge members are mired in bear markets.    

Just like past equity bubbles, the early returns were awesome, trumping just about every traditional method of stock investing. But as our Chart of the Week shows, even before the Fed begins its tightening, the market for these types of investments has soured. Three bellwethers of recent market excess — the ARK Innovation ETF (ARKK), IPOX SPAC Index and Renaissance IPO Index, are each down between 30% and 45% since their peaks in mid-February 2021.           

Being a value investor can be painful at times as investor enthusiasm and returns can be found in the silliest places. But there is nothing more painful or memorable than losing money. As Mark Twain once said, “History doesn’t repeat itself but it often rhymes.”    

Key Takeaway     

Value investing is not usually considered to be cool or fun, especially during periods of market excess — and certainly not compared to the hottest and newest growth companies and investments. The old, stodgy methods of due diligence and financial ratio analysis anchor us in financial reality, helping us avoid bubbles and periods of malinvestment. The market ultimately has a way of punishing bad decisions that are solely based on euphoria versus fundamentals.

In this recent period of excess liquidity, it appeared for a time that fundamentals no longer mattered. If the Fed follows through with the expected taper and hikes in the coming year, I’d be willing to bet the only thing that will matter is fundamentals, and the euphoric bubble of 2020/2021 should fade into its place in market history.


Index Definitions:

The IPOX SPAC Index is a benchmark for the performance of a broad universe of Special Purpose Acquisition Vehicles (SPACs) by applying the IPOX Indexes Technology.

The Renaissance IPO Index is a diversified portfolio of US-listed newly public companies that provides exposure to securities under-represented in broad benchmark indices. IPOs that pass a formulated screening process are weighted by float, capped at 10% and removed after two years.

Tags: Federal Reserve | COVID-19 pandemic | Liquidity | Markets | Investing | SPACs | Value Investing

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