The Next Bubble?

by Jeffrey Kleintop, CFA®, Senior Vice President, Chief Global Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• Investment bubbles are a regularly occurring feature of the financial markets. The specific set of conditions that have historically characterized the start of an investment bubble appear to be forming.
• While notoriously hard to pinpoint in real time, a theme with the potential to become the next bubble is “green” infrastructure.
• The green infrastructure theme spans many sectors and markets around the world.

Hundreds of years of history shows us that investment bubbles have been a regularly occurring feature of the financial markets. For as long as humans have been trading investments, whether in commodities, real estate or equities, there have been periods of time when the prices of assets have become disconnected from their underlying value. Although bubbles typically are identified after they have popped, there is a repeating pathway characterized by a specific set of conditions that helps to predict them. The conditions appear ripe again for the start of the next investment bubble.

Conditions are ripe

Investment bubbles often begin as a natural byproduct of extremely stimulative polices enacted in the wake of global recessions. They are born of easy money, grow on speculation fueled by a strong fundamental theme and high investor confidence, and collapse as money tightens, usually well after disconnecting from intrinsic value. The specific set of conditions that characterize the start of an investment bubble appear to be forming.

• Easy money. Currently, signs of easy money abound in the form of record-breaking fiscal and monetary stimulus around the world, abundant private sector investors seeking investments (ex. Special Purpose Acquisition Company (SPACs), the GameStop retail trading frenzy, Non-Fungible Token (NFTs), cryptocurrencies), and the return of corporate share buybacks as excess cash burdens corporate balance sheets after last year’s precautionary pause.
• Strong fundamental theme. Speculative bubbles generally start with strong fundamental theme accompanied by a high degree of investor confidence in this theme becoming a new paradigm or new normal. Examples from past cycles include: Japanese real estate in the 1980s, tech stocks in the 1990s, and home prices in the 2000s. An investment theme with the potential to become the next bubble may be “green” infrastructure. Investment bubbles often include infrastructure: e.g. the South Sea Company in the 1700s, telegraph companies in the 1800s, railroads in the early 1900s, and internet companies in the late twentieth century. The massive green infrastructure spending plans from the U.S. Biden administration, the ambitious “Green Deal” by the European Union, and China’s proposal to improve on the impacts of economic growth through cleaning up production, all to be deployed in the years ahead, point to a strong fundamental theme with rising confidence by investors in green infrastructure.

A “green” theme

Alternative energy and other green stocks could benefit from proposed U.S., European, and Chinese climate and green energy legislation and spending including electric vehicles, renewable power generation, eco-friendly infrastructure, and home energy efficiency. The scope of the initiatives is bold and includes wide-ranging goals:

• Modernize the electrical infrastructure: upgrade the aging U.S. electrical grid and the addition of more renewable energy sources in the U.S., Europe and China.
• A major shift to zero-emission vehicles: U.S. tax credits for consumers buying zero-emission vehicles, municipalities purchasing zero-emission public vehicles, incentivizing electric car manufacturing, and increasing availability of vehicle charging infrastructure. China, the world’s biggest car market, is targeting electric vehicles make up 20%of sales by 2025.
• Transition to renewable energy: extensions and enhancements of U.S. tax incentives for businesses to deploy renewable energies such as wind, solar, biodiesel, and electric vehicles. Consumer tax incentives for consumers to reduce carbon use.
• Modernize European industries like steel, chemicals, cement and other energy intensive manufacturing.
• Promoting smart-technologies and eco-friendly European infrastructure to support a shift from road freight to rail and waterway freight.
• China’s vision for the next five years is based on a green transformation of its economy, following widespread air and water pollution after two decades of rapid industrialization. Plans include new infrastructure, wider use of renewable energy and cutting the production capacity of resource-intensive industries.

All these green initiatives are supported by substantial funding plans. For example, a full 30% of the EU’s €1.8 trillion budget and recovery plan for 2021-2027 is intended for a transition to green infrastructure. Biden’s plan includes $174 billion in proposed funding for electric vehicles alone. China’s investment in a greener future isn’t defined by the programs cost, but it’s safe to assume it will also be sizable given the size of their economy and the scope of the planned transition.

“Green” stocks set to inflate?

In a hint of what could come, the lead up to last year’s U.S. elections saw alternative energy stocks outperform traditional energy stocks by a very wide margin, roughly 100%, as you can see in the chart below. Europe’s Green Deal and candidate Biden’s emphasis on climate initiatives, combined with his lead in the polls, gave these stocks a boost. But, that performance gap has narrowed sharply this year as oil prices moved up from $45 to $65 per barrel, supporting traditional energy stocks. Some green high-flying growth stocks pulled back as interest rates jumped. What unfolded appears to have been a classic case of “buy the rumor, sell the news.”

Alternative energy vs. traditional energy stocks

Source: Charles Schwab, Bloomberg data as of 4/11/2021. Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Green stocks now appear to have given up last year’s gains and the recovery and stimulus driven gains in oil prices and interest rates appears to be moderating. This could mean it may be time for “green” stocks to begin to inflate again as progress is made on the Biden infrastructure plan and Europe gets closer to deploying its green funding initiatives.

Green theme spans sector and countries

Often past bubbles have been concentrated in just one sector and country (ex, U.S. tech stocks). In contrast, a green stock bubble will span many sectors and markets around the world.

• Diversified by sector: Green stocks go beyond merely alternative energy companies. The green infrastructure theme also includes traditional industries such as industrial machinery, electric utilities, semiconductors, and electrical equipment, among many others.
• Diversified by country: Publicly traded companies in green infrastructure come from many developed and emerging market countries including the U.S., Spain, Denmark, Canada, New Zealand, China, Austria, Israel, Brazil, Norway, the U.K., and Germany. 72% of the S&P Global Clean Energy Index is composed of non-U.S. companies.

Global clean energy index is globally diversified

Source: Charles Schwab, Bloomberg data as of 4/10/2021.

Inflating valuations

Bubbles are notoriously hard to pinpoint in real time and there are a number of themes that could emerge next. As the new economic cycle gets underway, a new investment bubble is likely in the early stages of forming, leading to wide-reaching economic and market effects. Although the bursting of a bubble can help drive a global recession, the preceding multi-year inflation can help sustain stocks’ high valuations or possibly propel them even higher.

Michelle Gibley, CFA^®, Director of International Research, and Heather O’Leary, Senior Global Investment Research Analyst, contributed to this report.

Copyright © Charles Schwab & Co., Inc.