Are we in a bubble?
In this episode, Lochlan Halloway, Equity Market Strategist, joins us to discuss what we can learn from market crashes.
Every investor fears the next market crash but what actually causes them, and how can you prepare?
In this episode, Mark sits down with Lochlan Holloway, Morningstar Australia’s Equity Market Strategist, to break down the psychology and patterns of market crashes, from the Great Depression to the GFC and the rise of AI stocks today.
Lochlan explains why no two crashes are the same (but they often rhyme), why predicting crashes is impossible, and how investors can prepare both financially and emotionally for when markets inevitably turn.
You can find the transcript for the episode below:
Shani Jayamanne: Mark and I have had very different lives. Mark had his first investment before the age of 10. I started investing after I started full-time work. Our lives, financial goals, and experiences have meant that we have very different investment strategies.
LaMonica: We do have a few things in common, though. The first is that we’ve spoken to hundreds of investors about their journeys and understand what is most helpful for them.
Jayamanne: The second is that we both work at Morningstar because we’re able to do this with independence. We don’t have to recommend a particular product or asset class. Our only vested interest is in helping you achieve your outcomes.
LaMonica: The last is that although we have vastly different life experiences and differing investment strategies, the fundamentals and the underlying principles that we follow are the same. And it’s these principles that we take a deep dive into in our book, “Invest Your Way.”
Jayamanne: “Invest Your Way” is a guide to successful investing with actionable insights and practical applications. It focuses on the investor instead of the investments. You’re able to purchase the book and audio book through the links in the episode notes, through major bookstores, or request a copy through your local library.
Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.
LaMonica: All right, big day for us today, Shani. We have another guest episode and Will turned the lights down. So, we’ve got mood lighting in here.
Jayamanne: It’s moody in here.
LaMonica: Yeah, exactly. I was saying that we should have a glass of red wine, but nobody has brought me one yet. So today, our guest is Lochlan Halloway, who is our equity market strategist here at Morningstar in Australia. So, he sits with our equity research team and he writes “Your Money Weekly.” So, subscribers to Morningstar Investor should be familiar with that. And yeah, we think we’re excited about the guest today.
Jayamanne: Yeah, so as well as this, he does provide broad stock market analysis using valuations from Morningstar’s equity research team. He also contributes to fundamental research on ASX-listed companies in the consumer, industrials, and basic materials sectors.
LaMonica: And before joining Morningstar in 2023, he was an advisor at the Department of the Prime Minister and Cabinet, which is pretty impressive. And he was focusing on fiscal policy there. And he also previously worked as an economist at Westpac.
Jayamanne: Very impressive. And I think what we like about Lachie is that he has a really deep interest in economics. And he is able to explain to us about how and why markets behave the way that they do in a way that makes sense. So, we want to speak to him about market crashes.
LaMonica: And we haven’t had an extended market crash for a very long time, so long in fact, that many investors who are listening to this podcast wouldn’t have experienced one of those drawn-out bear markets. So, we want to start by looking backwards. So, we’ll look at the pattern of market crashes and Lachie will offer some lessons on what investors can learn from these patterns, depending upon what happens going forward.
Jayamanne: And then we’ll look at the present and the future. We’ll home in on valuations, how investors should use valuations in decision-making, and how it should influence their portfolio and their approach.
LaMonica: Okay, let’s get into it. So, here’s our interview with Lochlan Halloway, the equity market strategist at Morningstar.
Well, Lachie, thank you very much for joining us. We start every guest with the same question. You are a market strategist, and I think a lot of listeners hear these titles in the industry and want to know what people do day to day. So, what does a market strategist do?
Lochlan Halloway: Yeah, sure. So, Morningstar Equity Research, we’re predominantly a team of fundamental bottom-up stock-level analysts, or analysts each cover 20 or so ASX-listed stocks. My role is to sit above the sort of granular stock-level research and try and draw out the sort of big market-wide insights. So, is there a particular pocket of value opening up in this sector of the market, or this sector of the market, or this style, or this theme? So, it’s about finding the larger insights from the bottom-up individual valuation work and then communicating. That is like I do today.
LaMonica: Yeah, so you make a lot of media appearances, none obviously as big as this.
Halloway: Of course not. This is the big one, Mark.
LaMonica: But yeah, so Lachie has been warming up for years to this moment. But we thought we would talk about market crashes. And the reason we want to talk about that is everywhere you look, there’s talk of bubbles. And obviously, I think people are implying that if there’s a bubble, there will then be a crash. And it has been a while. So, a lot of particularly younger investors haven’t really experienced what we would call a crash. So, what do you think is important for investors to understand about market crashes so they can prepare if one does occur?
Halloway: Look, I think the overarching insight, to be perfectly honest with you, is that crashes actually – they always end. I think Morningstar has done a lot of thinking about market crashes. And we have a very long series of US equity data and global financial markets data. I think the core insight is that they end, but also they are certainly a feature and not a bug of risk markets.
That is, in my view, the price of admission. If you want equity-like returns, you have to accept equity-like risk. They are going to happen. They happen with a high degree of regularity, (perhaps in) financial market history. They do end, but you have to be ready for them. And I think knowing that from a financial perspective, but also psychologically being conscious of that is important for investors.
LaMonica: Yeah. Now it probably does not come across to listeners, but we actually prepare for this stuff. And we talked prior to coming on there and you made a statement, I’m going to quote you to you. You said that no two crashes are the same, but they tend to rhyme. And so, what do you mean by that? It’s implying there’s a pattern. What is that pattern?
Halloway: I think it draws on work by one of the great thinkers and scholars of financial crises, Charles Kindleberger, who wrote one of the seminal texts on financial market crises and crashes. That was his “Manias, Panics, and Crashes” in 1978. I think the book is in its eighth edition now, showing just how relevant the theme is today as it was back then, when in the middle of the Volcker oil shock, big bear market of the 1970s. He proposes in that book a framework, a process for understanding the boom and bust psychological cycle of markets. He draws on work from a contemporary economist, Hyman Minsky. I think the great insight or one of the great insights about this is that he doesn’t make it dense or mathematically heavy or quantitative like a lot of economics does. He makes it very much a qualitative, psychological look at the cycle of bubbles, which is great. It’s easy to remember and easy to understand. And I think that’s generally a good thing for economics.
The way he characterizes the boom and bust cycle, he outlines a five-step process. The first step, he calls it displacement. So, something new comes along, a new bit of technology, some external macroeconomic change, structural shock that starts off visions of great potential, great promise. He then moves on to the boom stage. That’s the next bit where investors really start to pay attention. You start to see optimism building, credit coming into the sector. That sort of creates a bit of a reinforcing cycle, prices go higher, so you become more confident, the prices go higher and so on. The third stage is this euphoria or this mania stage where it’s just everyone wants in, it’s get rich quick, it’s Keeping Up with the Joneses. It is credit and leverage, pumping up prices, speculative finance. That is the real sort of peak bubble part of the cycle.
Distress is the fourth of the five stages. So, in that part, we have some cracks starting to emerge, profit taking, maybe a lead is stumbles in the theme, maybe a fraud is discovered. And then the final stage, which is revulsion, which is the crash, massive unwinding of leverage, investor pain, creditors don’t want to lend, liquidity crunches. Everyone promises this will never happen again and we recover and the cycle repeats.
So, all of that to say that it’s primarily a psychological, not a sort of mathematical process. It has happened many, many times throughout financial markets history and then almost certainly will happen again. The trigger is not always the same, but that general process, that general shape is pretty consistent throughout financial markets history.
LaMonica: Okay. I think the psychological side of it is kind of interesting, because obviously, what you’re really talking about, these are investor emotions. So how would you suggest somebody prepares, I guess financially as well, but also psychologically for a crash, which will be inevitable at some point, not saying necessarily it’s happening tomorrow, but at some point in most investors’ lifetime, in all investors’ lifetime, this does happen. So yeah, how can you prepare?
Halloway: Look, I think I’ll invoke the great quote from Dwight Eisenhower here that – plans are useless, but planning is indispensable. Which kind of sounds a bit paradoxical, but basically the idea is that when a crash inevitably happens, whatever grand, finally articulate blueprint you’ve developed is probably going to be torpedoed because these things come out of unknown places at unknown times and things blow up and the plan often doesn’t go – it doesn’t play out as you’d expect. But the process of planning and thinking about where’s my risk concentrated? If something happens, what am I going to do? Developing a pick list can reveal to you potential frailties in your portfolio or in your broader financial health. They might be useful in the lead up to a crash.
There’s not necessarily a lot you can do in the moment, but you certainly can control your behavior. Predicting a crash is basically impossible, I would argue, and I wouldn’t advocate trying to do it. But thinking about your financial wellbeing, am I heavily concentrated in one asset or one underlying theme? Am I really reliant on a particular thing going on? If a crash happens, do I have enough liquidity to fund my lifestyle and my other goals? I think that is the more important big picture thing about thinking about crashes.
LaMonica: Okay. Now you made the statement that predicting a crash is impossible. But now I’m going to ask you to predict one. So, are we in a bubble? There’s all this bubble talk. There’s talk about AI and tech valuations. What do you think?
Halloway: Well, lean on the research from our US technology team, because that’s where all of this interest is concentrated. The MAG7 right now, according to our fundamental analysts, are pretty close to fairly valued from a bottom-up research perspective. So that would suggest we are not in bubble territory in and of itself. An awful lot of potential reward in AI, but a lot of risk too. So, a lot of those stocks that we cover in the MAG7, they’re high, a very high uncertainty rating stocks. We think the market has broadly got the valuations about right now. They’re not screaming as cheap, undervalued buys, but they don’t look excessively priced either, might has got it about right.
There’s an immense amount of potential in AI. If we look at the MAG7 as a group, they’re trading on an average of about 30 times earnings, excluding Tesla, which is not, I think, crazy for fast growing, fairly capital light, high margin, cash flow generative established businesses. Commonwealth Bank is on a 30 times earnings multiple. So, I don’t think that’s crazy to pay some of that for a stock like Nvidia. We don’t know how it’s going to play out, but it doesn’t seem dotcom era, concept stock 100 times earnings multiples plus.
So, the short answer is no, I don’t think so yet in that particular corner of the market. I’d also point out that the credit, the leverage side seems reasonably okay. It’s not like these hyperscalers are massively indebted, yet they’re funding a lot of the CapEx out of free cash flow, which is also generally good. So, in AI, I would say no, we don’t see a bubble, at least not yet.
LaMonica: Yeah. And we’ll go back to that in one second, but you did make a statement about uncertainty. So that’s a rating that our analysts put out. Could you just briefly explain what that means to listeners because I think there’s uncertainty about the uncertainty rating.
Halloway: Sure. So, the uncertainty rating is our way of trying to communicate or put a label on how confident we are in the forecasts that underpin our valuation for stocks. So, if we think about a very – in theory at least safe stock, like an infrastructure asset, a railroad and a port, you’ve got pretty good visibility on earnings over a fairly long horizon, especially if they’re contracted earnings. So, we can be pretty confident in the valuation that we give a stock, like a railroad or a port is probably pretty close to its intrinsic worth. There’s not a lot that we think can go wrong. Always tail events, fine, but we can get a pretty good beat on where that business is heading.
Something like AI, a company like Nvidia, which is, we’re talking like our industry, which is sort of 50% year-on-year growth rates. It’s very hard to have a great degree of confidence multiple years ahead about where that industry is going to be. We have our base case forecast. We have a point estimate for where the earnings will be. We have to recognize that the band of possibilities is much wider around those sorts of stocks. So, when we label a stock like Nvidia with a very high uncertainty rating, what we’re saying is that these are our estimates, they are our best endeavor to make a forecast about the earnings for this company. But it could be very different, both on the upside and the downside.
LaMonica: Yeah. And to add my own two cents, I think it’s really important for investors to realize that not every company is the same. And so that’s why it’s important to find things that you’re comfortable investing in. And that could be something with this wide range of outcomes, or something, as you said, that’s very predictable.
Let’s get back into sort of AI and dotcom bubble. And once again, we talked about this a little bit before, the pre-interview discussion we had. What are the differences if we go back and look at that dotcom bubble, we talked about pets.com, for example. What are the differences? You mentioned some of them that these companies are obviously established, have a lot of cash. But what other differences do you think between the two?
Halloway: Look, frankly, I think that’s the main one is the established nature of basically all the MAG7 being viable, profitable businesses well before this generative AI theme was really a thing. Apple was still a fantastic business well before AI, and it still is. And there is a very rock-solid core business there in the case of most of the MAG7. That is not the experience for many companies during dotcom, like pets.com is the archetype example of how to domain name. And at that time, we thought you had to have a good domain name, because that’s how you drive traffic in the net before search engines and so on. And it was just crazy, crazy valuation for something that was totally unproven, and really had nothing there in the end.
I would say that the big leaders of US equities today, and this is the view of our analysts, they are genuine businesses. They are funding, as I said, a lot of this expansion through their own free cash flow. They are not relying on IPO financing or debt to do that. That’s positive. And I think it puts in a little bit more of a safety buffer there than just pure raw speculation. I’m sure there are pockets of that going on right now today. But for the big stocks, the MAG7, the hyperscalers, it doesn’t seem like it’s directly comparable to dotcom.
LaMonica: Yeah. And then those are obviously what will drive the overall market, because they make up such a big part of it. So, something we talked about was Howard Marks, and his view on where things are, and he is using what he calls the INVESTCON scale. So maybe talk a little bit about that, because I think it kind of reinforces what you’ve been saying as well.
Halloway: Yeah. So, I think the way that Marks – he used INVESTCON as a – when he drew the parallel with the DEFCON scale, the Defense Readiness Condition, which Hollywood kind of popularizes as the nuclear threat level. I think DEFCON 5 is like low thread, everything is kind of easy breezy and DEFCON 1 is like nuclear Armageddon is on the brink. He mapped that across to the investing landscape. He used a 6-notch scale where INVESTCON 6 was, okay, maybe you stop putting new money into risk assets, you go up to the next notch, maybe you’re tilting a little bit defensive, all the way up to, you’re either stuffing cash under the pillow, or you’re going short in the market kind of up at the one DEFCON or INVESTCON 1.
He describes today’s market is about INVESTCON 5. So, one notch above the lowest threat level. I think that’s probably reasonably similar to the way we see things today that, yeah, they’re a little bit expensive, but this doesn’t look totally crazy to us. And we would also – I would temper that or I would add the caveat that in the short term, at least, valuations are not a great predictor of equity market returns. And just because the CAPE Shiller price/earnings multiple is very high, does not mean that a crash is imminent. This may well go on for quite a long time. And to sit that out is potentially a big error of omission opportunity cost, as opposed to staying in and riding through a potential correction should one come. So, he puts it something like, valuations are a bit stretched, but not nutty. I think we’re probably in a similar boat if I look across our coverage.
LaMonica: Yeah. How much do you think – obviously, your team very focused on valuations. How should investors think about that as things kind of bounce around between – and you said things are not too nutty, but get a little fairly valued, overvalued versus when things are cheap. How should people think about that?
Halloway: Yes, I think it’s a long-term compass. Valuations over 10-year, they are strong determinant of future returns. Over a short time horizon, a quarter, six months, a year, maybe even a couple of years, it really doesn’t have a great statistical historical correlation. So, I would argue they’re not a timing tool. They may be a long-term sort of strategic asset allocation thing, maybe a little more this way or that way. But they’re not for timing the market or predicting a crash.
I mean, a great example, and I’ll tribute this to Aswath Damodaran, another thinker about corporate finance. He had a look and when Greenspan was warning about irrational exuberance in 1996, if you pulled your money out of equities and put it into cash, you would have underperformed an investor who just stayed invested the whole time, rode the bubble for the next five years, crashed and then started rebuilding from there. So, the smartest people in the room can still say that equity markets are expensive and overpriced. You may very well be better off just sitting in there and riding it out. So, I think the original point, it’s a long-term compass. It’s a tool to make you a bit more aware of concentration and being a bit more selective, but it’s not a timing tool.
LaMonica: Yeah. And I think related to that, it’s November 6. We’re recording this on November 6. Now, markets went down for three days at the beginning of this week. And predictably, I follow all of these different investing Facebook groups, and it’s buy the dip, buy the dip, buy the dip, and markets have not gone down a lot. Very minor moves, but down. And we’re getting all this behavior. And I think that we’ve seen this a lot. And I think people are conditioned, back to what we were talking about before, that there hasn’t been a big crash in a while. So, people are conditioned every time the market pulls back a little bit to “buy the dip.” What do you think about this? What are what are the potential issues with that type of behavior?
Halloway: Yeah. So, in the very long run, history would suggest that buying the dip is going to work. As I said, right from the top of the program history shows that every crash has ended and equities eventually continued to march upward and to the right. In the short term, though, it can be very painful financially and psychologically through some of the most severe crashes of financial market history. Like, yeah, if we look at Liberation Day or DeepSeek or even COVID, you got to pay back very quickly if you bought the dip and credit to you for doing that. But every now and again, you get a complete mother of a crash. And it is – the drawdown is brutal and the time to recovery is long. If you bought in the GFC, US equities – this is specifically if you bought in the GFC after equities had corrected 20%, and we entered bear market territory, all equities ended up -- took a year-and-a-half and they fell 50%. So, you would had to stomach another 30% from peak before even bottomed and then took years to recover.
And if you held on the whole time, yeah, you would have done all right in the end. But a lot of investors, I imagine probably don’t have the conviction or the stomach understandably to do that. And we think about the great crash of ’29, the biggest crash that was 80% peak to trough. So, you buy after we’re in bear market territory, you’ve got a long time to fall when you’re in the red and a long time before it recovers.
I think the great example to try and understand, because I of course didn’t live through the great crash. I was alive during the GFC, but I was investing through it. So, it’s hard for me to sort of imagine how hard it is. But Paul Kaplan, who is the director of research here, he has done a lot of writing on bubbles. He developed this thing called the Pain Index, which is a way to sort of quantitatively measure how painful a bubble is or a crash is both in terms of the drawdown, but then the time to recovery. Very simply, what he did was he said, all right, if you can picture a stock market chart, it sort of gradually ticks up, but every now and again, every correction where it jots down and went back up again. If you colored in, if you filled in the little divot left by that dip, and then you benchmarked it against the size of the divot left by the Great Depression as a percentage, that sort of is a rough way of benchmarking how painful a correction was looking at the relative size of the huge hole left in markets versus the great crash of ’29.
COVID was a pain index of 2%, 2% as painful as the Great Depression. And I remember COVID and it felt very painful and very financially distressing and sort of existential. Imagine something 50 times worse and trying to ride that. That is the – yeah, buying the dip, long run it works, but I think it’d be very painful in the short term and you got to have a stomach to do it. It’s paid off recently, but it can be long and it can be painful, history would suggest.
LaMonica: Yeah. And I’m pretty old, but I also missed that ’29 crash. But I do remember the GFC. I was working and investing and yeah, I think people that have not experienced stuff like that don’t really understand like how that breaks your will when it’s like years of it. And also, I think COVID is a little bit of an example because there was other stuff that was stressing us out, certainly health outcomes and everything else. But also, I remember I was very worried about losing my job. So, you have that on top of everything. So, it’s like another reason being like, oh, I should go to cash. I might lose my job. So yeah, there’s a lot of external pressures as well.
Halloway: Absolutely. And to that point about preparing, it’s like, well, you can’t foresee a COVID event totally like, Taylor is Black Swan thing that comes out of nowhere. But being aware if my dividend income is cut by 20%, or my portfolio falls by 30%, 40%, can I stomach that? And is that going to push me to negative equity or margin calls? Or I’m going to have to really cut spending or move out of my house or something like that? That kind of stress testing of your own portfolio is I think probably the greatest thing we can take out of the preparation phase and understanding crisis that we should be thinking about that well ahead of a correction.
LaMonica: Okay, great. I think we’ll leave it here. I thought it was a great conversation. We learned about INVESTCON. But thank you very much for joining. Really appreciate it.
Halloway: Thanks for having me.
(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)
Invest Your Way
A message from Mark and Shani
For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.
We’ve shared our journeys with you, and you’ve shared back. We’ve listened to what you’re after and created a companion for your investing journey – Invest Your Way. Invest Your Way is a book that focuses on the investor, instead of the investments. It is a guide to successful investing, with actionable insights and practical applications.
If anyone would like to support this project you can buy the book now. Thanks in advance!
