Ray Dalio: Are We Facing A Stock Market Bubble in 2024?

I think that 24 will be a pivotal year because we have all of these forces coming together in 2024. A lot of you guys know Ray Dalio. He is a very famous macroeconomic investor known for building Bridgewater Associates, which is the world's biggest hedge fund. Now, over the past few years, Ray has taken a step back from running Bridgewater, and he's now said that he's entering the stage of his life where he wants to try and pass on the knowledge that he has built up over time.

One of the primary ways Ray keeps us all informed of his current thoughts on the market is through his very detailed LinkedIn newsletter called "Principled Perspectives," which he now writes for over half a million subscribers. About 3 weeks ago, Ray released a new installment, which I think is a very interesting read, titled "Are We in a Stock Market Bubble?" The results might surprise you.

For those that don't know, Ray has this mathematically derived bubble gauge made up of 6 different categories that he checks in on from time to time to see how current conditions stack up versus those mega stock market bubbles of history. So this isn't purely Ray Dalio's opinion; the whole of this video is going to be his opinion based on the objective data that he analyzes.

As I said, for Ray's metric, there are six categories to determine whether we are in a bubble, and he talks about them all in this post. He says, quote, "I define a bubble market as one that has a combination of the following in high degrees:

1. High prices relative to traditional measures of value.
2. Unsustainable conditions (e.g., extrapolating past revenue and earnings growth rates late in the cycle, and capacity limits mean that that growth can't be sustained).
3. Many new and naive buyers who were attracted in because the market has gone up a lot so it's perceived as a hot market.
4. Broad bullish sentiment.
5. A high percentage of purchases being financed by debt.
6. A lot of forward and speculative purchases made to bet on price gains (e.g., inventories that are more than needed, contracted forward purchases, etc.)."

So those are the six main categories that he looks at, and that helps reform this chart here, which he calls the "USA Equity Market Bubble Gauge." As you can see, in 1929 the bubble meter was off the charts. In 1999 it was also off the charts. In 2021 it was pretty high, but interestingly, if you look at where we are right now, Ray's bubble gauge sits only at 52%.

He notes, quote, "When I look at the US stock market using these criteria, even some of the parts that have rallied the most and gotten media attention, it doesn't look very bubbly. The market as a whole is in mid-range, 52nd percentile, as shown in the charts. These levels are not consistent with past bubbles."

He goes on to actually give us the breakdown of the bubble gauge into its six different components that we mentioned before. As you can see, prices are relatively high relative to traditional measures and read as frothy. Prices discounting unsustainable conditions is somewhat frothy. New buyers entering the market reads somewhat frothy as well, but then broad bullish sentiment, purchases being financed by high leverage, and buyers have extended forward purchases, they are all reading no bubble.

If you compare that with, say, 2007 or the dot-com bubble or the Roaring 20s, as you can see, the gauge was much more worrying back then. So while getting some frothy readings on the scale isn't the best by this measure, it's still nowhere near as bad as what it has been in those genuine historical bubble moments.

But let's get more specific than the general stock market. Let's also hone in on what I would consider a very frothy subset of companies in the S&P 500, that being the Magnificent 7, the amazing set of seven mega-cap US tech companies that are responsible for a very large chunk of the performance of the S&P 500 over the last year or so.

See, the cool thing about Dalio's bubble gauge is that it can also be applied to a subset of companies as opposed to just the whole market. He also takes the time to go over their numbers in this memo, and when you look at just these seven stocks, you do start to see some more bubble conditions arising. As you can see from the table, for the general market, it showed frothy, somewhat frothy, somewhat frothy, and then three greens. However, for the Magnificent 7, the story changes: prices are relatively high, you get frothy; prices are discounting unsustainable conditions, you get frothy; new buyers entering the market, you get somewhat frothy; then broad bullish sentiment, you get frothy.

No surprises there, as it seems every man and their dog wants to tell you about how AI is going to change the world and the stock market forever. Interestingly though, purchases are not being financed by high leverage, probably because leverage is very expensive right now. Lastly, extended forward purchases are also yelling frothy, which makes sense as these businesses are investing heavily in their AI tech.

So, according to Ray Dalio, the stock market itself isn't in a bubble, but the Magnificent 7, as per Dalio's gauge, is certainly headed in that direction. There's no doubt frothy conditions make it really hard to find good opportunities in the stock market. Well, there might just be a potential solution for that.

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Now, going back to Ray Dalio's bubble gauge, for the next part of the video, I really wanted to go a little bit deeper and break down exactly why Ray sees things the way he does. Category one is high prices relative to traditional measures. As I said, the gauge reads frothy for the Magnificent 7. Ray says, quote, "Looking at the Mag 7, we are reading Alphabet and Meta as somewhat cheap and Tesla as somewhat expensive. We'd call the group in aggregate fairly priced."

I find this very interesting, particularly because they don't note Nvidia as being overpriced. However, he does go on to say that quote, "This value read is partly based on analyst expectations for growth, so we're assuming that analysts are making reasonable predictions for growth driven by generative AI. This is an area we have lower confidence because there is so much inherent uncertainty and because it is not our area of expertise." That almost sounds like a bit of an admission of guilt, like he knows that he's going to get comments about Nvidia.

But that does make more sense as to why Nvidia isn't screaming as overvalued by this gauge because a lot of analysts are caught up also in the AI trend, thinking it's going to turn every company under the sun into a multi-trillion dollar behemoth. But with that said, moving on to Category 2, which asks if prices are discounting unsustainable conditions. This was frothy for the Magnificent 7, and Ray says, quote, "This measure calculates the earnings growth rate that is required to produce equity returns in excessive bond returns. This is derived by looking at individual securities and adding up their readings."

On this category he notes, quote, "The Mag 7 looks frothy by this measure, but not bubbly. P/E's have come down from their co-highs but are still elevated relative to history, and these P/E's are baking in fairly high projected earnings growth, which is driven by expectations around AI for many of these companies."

As an example, the article shows an interesting comparison between Nvidia now and Cisco during the tech bubble. As you can see, both of these companies experienced massive share price gains. However, Nvidia's two-year forward P/E is around 27 today, whereas Cisco shot up to a forward P/E of literally 100 during the tech bubble. While I personally think Nvidia is a little bit bubbly, Ray does have a point that at least the explosion in Nvidia's market cap is coinciding with an explosion in their earnings.

While it's definitely frothy, it's not frothy for absolutely no reason this time round, as it was for a company like Cisco. Dalio notes that this has been consistent for the rest of the Magnificent 7, too. As you can see, the market cap and the earnings line has more or less risen and fallen together, so definitely an interesting topic to discuss; maybe not discounting completely unsustainable conditions, but that will depend on the success of AI in the next few years and whether companies like Nvidia can continue to grow into their current valuations.

Anyway, moving on now to the next category, and this one is new buyers are entering the market. Of course, a flood of new investors out of the blue is usually a pretty good indicator that you've hit the common folk and you're probably looking at a bubble. Ray Dalio notes that quote, "This gauge shot above the 90th percentile in 2020 due to the flood of new retail investors into the popular stocks, which by other measures appeared to be in a bubble. Today, the activity of new buyers is a bit higher than typical (55th percentile) but not particularly concerning. They note that about 28% of trading in the market appears to be retail versus around 35% in 2020."

When it comes to the Magnificent 7, Dalio says, quote, "Trading based on turnover remains near all-time highs in dollar terms, but as a share of the total market cap, it doesn't look like a speculative frenzy unlike the high levels of activity seen during 2020. As you can see, on average, around 0.75% of the Magnificent 7 market cap is being traded per day versus a high of 1.75% in the main year of 2020."

So new buyers are somewhat frothy but not as bad as it was a few years ago. Now, moving on to broad bullish sentiment, this is an interesting one because I definitely don't think there is market-wide bullishness in the air. I think there's a lot of hype in the Magnificent 7 right now, but I wouldn't say it's like that for the whole market, and Ray tends to agree. He says, quote, "Sentiment in the market is now neutral to slightly positive but not in bubble territory."

A good measure for this is actually IPO activity because there are usually a lot more IPOs in bubble conditions where sentiment is really positive. That makes sense, right? People listing their companies on the public markets want the most rampant speculative times to sell fresh new shares to investors. They want investors to be just pumped up about absolutely everything, right? Dalio notes, quote, "IPO activity, which is a useful data point for equity market sentiment conditions, had been running at extreme highs leading into 2022 as a boom in SPACs and strong equity market conditions drove rapid share issuance. This is meaningfully reversed with little to no IPO activity more recently."

So sentiment broadly is reasonably subdued. However, when we turn to the Magnificent 7, the story does change a little. Dalio says sentiment around AI is quite bullish. You can see below that more than a third of recent earnings calls have included mentions of AI, and I am not at all surprised by this. It seems like you can't go 5 minutes researching literally any company without somehow bumping into some mention of AI.

So we are definitely facing broad excitement around AI, but interestingly Ray notes, quote, "Another way we can get a sense of speculative activity is by looking at the options market. We can see the options activity reached all-time highs during the 2022 bubble and is modestly elevated today," showing option volumes specifically in the Magnificent 7. You can see that activity is quite subdued now versus a few years ago, so not quite caught in a full Wall Street bets-induced bubble just yet. I'm sure it's coming.

Then from there, the second last category is whether purchases are being financed by high leverage, and this is one category that Ray is not concerned with. He says, "Our leverage gauge, which looks at the leverage dynamics across all the key players, looks healthy at around a 23rd percentile rating." For example, you can see below that household margin debt outstanding has declined meaningfully from its co-era peak and is now near 10-year lows.

All I can say on this one is thank goodness. Yes, I know it's because everyone is doing a little bit tougher right now and interest rates are higher, but still lower margin debt is good. I'm definitely with Buffett on this topic; I don't really like the idea of leveraging up to buy such a liquid asset like shares. Property, I can understand more because the market doesn't swing so quickly; it's less liquid. But having a big fat loan in order to buy shares that can fluctuate 10, 20, or 30% in the space of a week, that does scare me a little bit.

But luckily, leverage isn't a big player when it comes to the markets right now. Then from there, finally, we have the sixth category, which is the extent to which buyers made exceptionally extended forward purchases. So we're talking about things like capital expenditures and future investments. The idea here is to see where the businesses are extrapolating their current demand into strong demand growth going forward. Dalio notes, quote, "This gauge is at the 38th percentile, a bit less bubbly than our other measures."

You can see below that levels of capital expenditure for listed US companies are still at relatively low levels—that's capex as a percentage of sales. But Dalio also hints that forward purchases do look a little bit frothy for the Magnificent 7 because, of course, everyone is jumping on board the AI train, making a lot of investment in this new technology. He says, quote, "We see these companies investing significantly." You can see below that the capex for these companies is at all-time highs, both versus their own sales and as a share of the economy.

That is actually the reason that Nvidia is doing so well right now. The rest of the Magnificent 7, as well as lots of other companies out there, are investing heavily in AI hardware, which is exactly what Nvidia offers. So not surprising at all to see lots of investment happening right now in the Magnificent 7. Time will tell whether it pays off.

But with that said, that is Ray Dalio's opinion on whether we are in a stock market bubble. Generally speaking, he thinks it's a definite no, but he does admit the Magnificent 7 isn't there yet but is definitely trending in that direction. So definitely let me know as well what you think down in the comments below. How do you think the market's going to play out? Do you feel like we're in a stock market bubble or heading in that direction?

I'd love to hear what you guys have to say. New Money Education is linked down in the description if you wanted to check that out and support the channel and learn about investing, how to actually go through the full value investing strategy, including three valuation techniques—that is down in the description below. But apart from that, guys, thanks very much for watching, and I'll see you guys in the next [Music] [Music].