Bridgewater: Beware The Popping Of These Bubbles As Liquidity Runs Out

For some, it seems obvious that one or more “bubbles” are affecting the market, but there may be more bubbles right now than most investors realize. Ray Dalio‘s Bridgewater sees bubbles in several areas, including emerging technology stocks, special purpose acquisition companies (SPACs), cryptocurrencies, collectibles, non-fungible tokens (NFTs) and more.

A bubbly market

The Bridgewater team has studied bubbles and constructed measures showing whether markets or economies are in them. They based their views of which markets may be affected by bubbles on the measures they developed. The Bridgewater team added that the bubbles they are seeing are especially pronounced in the U.S.

They explained that the “unprecedented flood of liquidity” since the pandemic started caused their bubble measures to “flash red in certain pockets of global markets.” The Bridgewater team note the sizable government checks which supported Americans’ income, as lockdowns restricted their spending. Meanwhile, competition and technology have made investing cheaper and more accessible than ever before.

Of course, all bubbles pop when whatever is fueling them runs out, although no one can accurately guess the timing before they pop. The Bridgewater team found the recent market action to be interesting, noting that the question now is whether modest Fed tightening could start to deflate these bubbles. Another critical question is whether the deflation of the bubbles would be “healthy or ominous.” Bridgewater argues that it is a bit of both.

Although the overall markets are still close to their highs, a sizable percentage of the market has plunged. The Bridgewater team added that the “bubbliest” segment of the market has already plummeted more than 25% from its peak. However, other sources like Daniel Oliver of Myrmikan report that the prices of some assets have risen 10% since May.

Warnings about liquidity running out

Nonetheless, the Bridgewater team believes bubbles are starting to deflate as the significant trading volumes in speculative instruments have dropped off meaningfully from their recent peaks. Further, they point to sharp deleveraging among hedge funds in recent weeks. Additionally, bitcoin and many other cryptocurrencies have plunged by at least 20%, and the IPO and SPAC pipeline has quieted down.

Bridgewater believes that deflating bubbles at least partially is healthy, and the Federal Reserve would probably be happy to see it. I would add that the Fed thought in May that asset prices were too high, warning then that they may be “vulnerable to significant declines should risk appetite fall.” In recent weeks, stocks have been batted about amid rapid fluctuations in risk sentiment, as evidenced by the 67.22% surge in the CBOE VIX in November, according to With Intelligence’s Eurekahedge.

However, the Bridgewater team added that it isn’t always easy or desirable to manage the implications of deflating bubbles. They highlighted the recent action in the bubbliest parts of the market and the consequences they will look for.

For example, they will be watching sensitivity to liquidity in the markets. The Bridgewater team believes that the news about the Omicron variant triggered an acceleration in the markets last month. Meanwhile, liquidity is being withdrawn gradually, and the Fed seems set on its announced tapering plans despite the increased uncertainty in the markets.

They warned that the U.S. equity market is currently more sensitive to a withdrawal of liquidity than it has been at any other time in the last 20+ years. As a result, Bridgewater believes policymakers will offer support to any significant correction, although “it could get painful in the short term.”

Other market watchers have cited the impact of liquidity on the market recently. Craig Erlam of OANDA warned in an email on Tuesday that low liquidity was already weighing on stock prices. 

“Stock markets are bouncing back on Tuesday despite there being little of note to trigger the sentiment U-turn as whipsaw price action continues ahead of the holiday season,” Erlam wrote. “In the same way that we shouldn’t get too carried away with yesterday’s sell-off, which was likely caused by low liquidity and some pre-holiday season risk reduction, we shouldn’t read too much into today’s rebound. These are illiquid markets and omicron continues to be a huge cloud of uncertainty over them.”

Impacts from retail investors

Bridgewater also warned that retail investors had made substantial purchases across all sectors of the stock market. As a result, if the bubble bursts, retail investors who have used leverage may be forced to liquidate other positions, widening the sell-off.

The Bridgewater team also point to other ways the increased participation of retail investors will affect the market bubbles. For example, they cite the significant amounts of paper wealth being created among retail investors, which links asset returns to retail spending like it did in the late 1990s. 

Bridgewater explained that households are seeing the fastest increase in wealth relative to income in recent history. As a result, like in the 1990s, a sizable amount of the wealth increase came from liquid and mark-to-market financial assets like stocks, making it easier on the margin to see and spend gains.

In the 1990s, consumers cashed in and spent their gains, resulting in a strong link between short-term moves in the Nasdaq

NDAQ
and retail sales. The support from consumers spending their wealth added to the cyclical environment, boosting spending in the economy to new highs.

The link between spending and the Nasdaq is usually much looser than it was during the 1990s, but similarly today, the link between stock prices and consumer spending has tightened. The link was already starting to tighten in 2018 and 2019. Bridgewater added that the spending has begun to be unleashed as the economy reopens. However, if the bubble in the stock market pops, it would likely become a drag on consumer spending.

When looking at the retail flows across each of the channels they’re watching, it looks like the impact of retail investors has peaked, but Bridgewater believes they are still a dominant force in the markets. While retail cash equity and options trading slowed this month, whether the weakness rebounds or continues will drive when and how fast the bubble deflates, according to Bridgewater.

Bubble stocks

The hedge fund firm notes that the speculative flows from retail investors had created bubbles in a narrow segment, but retail investors own more than just the bubble stocks. Of course, they do own some companies and sectors disproportionately, like Tesla

TSLA
, which has received 25% of the flows from retail investors even though it is a much smaller share of the market capitalization.

However, retail investors have also bought significant numbers of shares of other tech companies like Apple

AAPL
, Amazon and Microsoft

MSFT
. The Bridgewater team added that retail investors have also participated in the rotation out of growth and toward value. The firm emphasized again that if the bubble bursts, retail investors, especially those who have utilized leverage, may be forced to liquidate other positions, widening the sell-off and spreading negative sentiment across the market.

Bridgewater believes that if a liquidity withdrawal is what bursts the bubble, the consequences will be much broader. The firm believes this lever is the one that is most likely to pop the bubble as the liquidity added by government stimulus checks and other support have increased discount rates and risk premiums. The implications are even worse when considering that U.S. equities are unusually sensitive to liquidity conditions and less sensitive than is typical to shorter-term economic growth.

Correction is small so far

Several of the most speculative areas of the financial markets started to fall from their recent highs even before the Omicron variant was revealed. However, the Bridgewater team notes that the correction remains tiny for now compared to the run-up, adding that what’s priced in for the “frothiest 10% of the equity market” still looks “very aggressive” to them.