The global financial markets are facing considerable challenges, which are being exacerbated by rising interest rates, geopolitical tensions and fears of recession. Particularly affected are the large technology companies, the so-called “Magnificent 7”, whose extreme valuations are increasingly met with skepticism. Ray Dalio’s “Bubble Gauge” provides a detailed analysis of whether we are in a market bubble. Developments on the stock markets could have a significant impact on the crypto market, which is prone to extreme volatility in times of economic uncertainty.
The Current Situation on the Global Financial Markets
In recent weeks, global financial markets have experienced a period of extreme volatility, with an estimated $6.4 trillion lost in market capitalization. This unprecedented development is roughly equivalent to the total value of the global crypto market being completely wiped out over a three-week period. This dramatic loss in value reflects a multitude of challenges currently facing the global economy.
Several factors have contributed to this situation. One key aspect is the rise in interest rates in Japan, which has occurred in response to ongoing inflationary problems. In recent months, the Japanese central bank has tightened its interest rate policy, which has led to uncertainty not only in Japan but worldwide. This measure has a direct impact on global financial flows, as Japan is a major player on the international financial markets. The higher interest rates make capital more expensive and access to cheap financing more difficult, which, combined with the already tight global economic conditions, has led to a decline in the stock markets.
Geopolitical tensions have also played a significant role in this downward trend. Conflicts and uncertainties in various parts of the world, particularly in geopolitically sensitive regions, have had a significant impact on investor confidence. These tensions have led to a retreat from riskier assets, which has increased selling pressure on equity markets worldwide.
Another factor that has contributed to the recent turmoil is the exchange rate issue. The strength of the US dollar against other major currencies has further exacerbated financial conditions. Many international companies, particularly in emerging markets, are suffering from the burden of their US dollar-denominated debt as it has become more expensive to repay. This has made the global market even more unstable and led to additional losses in the equity markets.
Rumors of an impending recession have added to existing concerns. This speculation is fueled by weak economic data and a number of negative forecasts pointing to a slowdown in the global economy. The prospect of a recession often leads investors to shift their assets into safer havens, further accelerating the downward trend on the stock markets.
Of particular note, however, is the sharp fall in the shares of technology companies in Silicon Valley, which is seen as a kind of trigger for the recent turbulence. The so-called “Magnificent 7”, a group of seven major US technology companies, have achieved unprecedented market capitalization in recent years. These companies, which include Microsoft, Apple, Tesla, Alphabet (Google), Amazon, Meta and Nvidia, accounted for around a third of the total market value of the S&P 500 until recently. Their extraordinary growth was fueled above all by the hype surrounding artificial intelligence (AI), which has increased massively since the end of 2022.
In the wake of this development, the share prices of these companies have risen dramatically. For example, Meta, formerly known as Facebook, has seen a 546% increase from its lows in 2022. Nvidia, a leading provider of graphics processors, which are crucial for AI applications, even saw its share price rise by 1200%. These massive gains led many investors to start questioning the valuations of these companies, especially as the real economic benefits of AI are still uncertain.
In summary, the current situation in the global financial markets is characterized by a number of complex and interrelated factors that have led to a massive drop in value. The combination of rising interest rates, geopolitical tensions, exchange rate issues and recession fears has created a perfect storm that is weighing heavily on the markets. Silicon Valley’s major technology companies have been particularly hard hit, and their enormous value growth in recent years is now being put to the test. The coming months will be crucial to see whether the markets can stabilize or whether we are facing an even bigger correction.
The “Magnificent 7” and the AI Hype
Since the introduction of ChatGPT by OpenAI in 2022, the hype around AI technologies has driven up the share prices of the big tech companies. Microsoft, Alphabet (Google) and Amazon are well off their 2022 lows, and even Meta and Nvidia have seen impressive share price gains. These companies dominate the S&P 500 Index, which tracks the 500 largest US companies, and have contributed significantly to the overall market performance. However, the question is whether these extremely high valuations are actually justified or whether we are dealing with a bubble driven by speculative expectations about the future of AI.
Magnificent 7 Index Chart (Source: CNBC)
The uncertainties around AI investments
Although the hype around AI has driven prices higher, the long-term winner of this technology is still uncertain. Nvidia currently dominates the market for graphics processors, which are essential for AI applications, but whether this dominance will continue remains questionable. Furthermore, there is no clear indication that AI investments will be profitable in the short term. Research and development in the field of artificial intelligence is extremely costly and it remains to be seen whether this expenditure will actually translate into profitable business models.
The Increasing Skepticism of Investors
According to recent developments in the financial markets, there has been growing skepticism among investors, particularly in relation to the large technology companies known as the Magnificent 7. This group, consisting of Microsoft, Apple, Alphabet (Google), Amazon, Meta, Tesla and Nvidia, has made huge gains in recent years, mainly due to the hype surrounding artificial intelligence (AI) and related technologies. However, since mid-2024, the tide has turned and the previously seemingly unstoppable price rises of these companies have stalled.
In July 2024, the “Magnificent 7” experienced a dramatic correction that significantly reduced the market capitalization of these companies. In just 20 days, they lost an average of 125 billion dollars a day in value, amounting to a total loss of 2.6 trillion dollars. This sudden drop has unsettled many investors, causing them to rethink their strategies and rebalance their portfolios.
One of the main causes of this turnaround was the publication of the Magnificent 7’s quarterly results for the second quarter of 2024. Despite solid profits and, in some cases, better-than-expected results, the stock markets reacted negatively to these reports. For example, Microsoft’s share price fell by up to 8 % in after-hours trading, although the company reported a 15 % increase in revenue compared to the previous year. The decline was due to disappointing growth figures in the Azure cloud business, which grew by 29%, while analysts had expected 30%.
Alphabet (Google) also suffered a setback as its shares fell by 5% following the release of its quarterly results. Although the company’s revenues exceeded expectations, its significant investment in AI infrastructure caused concern. Alphabet announced that it invested $13.2 billion in fixed assets in the second quarter of 2024, particularly in building AI models. This sum was double the amount spent in the same period last year. Investors reacted with concern to this massive spending, especially as the return on these investments remains uncertain.
Alphabet Class C Stock 1 Year Chart (Source: Tradingview)
The “great rotation” in the markets began on July 11, 2024, when the US Department of Labor released surprisingly lower inflation data, raising hopes of a rate cut by the Federal Reserve in September. This development led to investors beginning to reallocate their capital from highly valued technology stocks to smaller, undervalued companies. The Russell 2000 Index, which tracks small US companies, had previously traded sideways for almost two years, but now these stocks began to rise as the prospect of lower interest rates increased their attractiveness.
Another reason for the increasing skepticism towards the Magnificent 7 is the uncertainty about the future development of the AI industry. While investors have been optimistic in recent years and accepted high valuations, doubts are now beginning to emerge. The enormous investments that these companies are making in AI raise the question of whether this expenditure will pay off in the foreseeable future. For example, ChatGPT, a product from OpenAI, costs an estimated 700,000 dollars a day to run. Since its launch, the company has already spent around 427 million dollars on operations alone. Such enormous costs, with no clear indication of short-term profitability, have led investors to reconsider their expectations for the future of AI and the profits that come with it.
Investors’ reaction to these developments is reflected in market dynamics. While mega-cap technology stocks, long considered a safe investment, are undergoing a correction, smaller companies are gaining ground. This rotation suggests that investors are increasingly concerned about the extremely high valuations of the Magnificent 7 and are looking for ways to reduce their risk by shifting into less valued and potentially less risky assets.
In summary, investors’ increasing skepticism towards the big tech companies is the result of a combination of stretched valuations, uncertainty about the profitability of AI investments and reaction to macroeconomic developments. The correction in July 2024 marks a turning point where the previously unchecked rally of these companies stalls and investors begin to rethink their strategies. How this scepticism develops in the coming months will determine whether we see a continuation of this correction or a stabilization of the markets.
What Is a Bubble and How Do You Recognize it?
A market bubble occurs when speculative buying drives asset prices far above their intrinsic value. This often happens through the expectation of continuously rising prices, which in turn attract more buyers, until finally no more new buyers can be found and prices collapse. Historically, bubbles are often only obvious in hindsight, such as the dotcom bubble in 2000 or the real estate bubble in 2008. The current situation on the US stock market shows some parallels to these historical bubbles, but whether we are actually in such a phase remains debatable.
The “Bubble Gauge” from Ray Dalio
Ray Dalio, founder of the world’s largest hedge fund Bridgewater Associates, has developed a method to identify the presence of a market bubble. This method, known as the “Bubble Gauge”, is based on an analysis of six key factors which, taken together, should provide a comprehensive picture of whether a market is in a bubble. Dalio is known for analyzing markets and economies in a systematic and data-driven way, and his Bubble Gauge is one of the most sound approaches to identifying potential market exaggerations.
Factor 1: High prices relative to traditional benchmarks
The first factor Dalio examines is the price level relative to traditional valuation measures, such as the present value of future cash flows relative to interest rates. When asset prices are extremely high relative to these traditional measures, it can be a sign of a bubble. In terms of the current US equity market, and the Magnificent 7 in particular, Dalio noted in the first quarter of 2024 that valuations were high but not extreme. This indicated that while market prices were set high, they were not yet in a range typically associated with a bubble.
Factor 2: Prices reflect unsustainable conditions
The second factor examines whether prices reflect conditions that are unsustainable. This includes, for example, the extrapolation of sales and profit growth rates in phases where capacity limits are reached and further growth becomes difficult. Dalio found that in the first quarter of 2024, the prices of the Magnificent 7 did not yet indicate unsustainable conditions. Valuations at the time seemed to reasonably reflect the expected growth, although they were already at a high level. The fact that companies largely exceeded earnings expectations in the second quarter of 2024 supports this view, as prices did not appear to be based on unrealistic assumptions.
Factor 3: New buyers entering the market
The third factor relates to the presence of new buyers entering the market, further driving up prices. When a large number of new market participants invest, often driven by fear of missing out (FOMO), this can reinforce the signs of a bubble. In the first quarter of 2024, Dalio found that while an increase in trading volume was observed, it remained moderate and did not cause concern. Interestingly, trading volumes increased significantly in the second quarter of 2024, almost tripling from June to July, but this was mainly due to selling as part of the “great rotation”. There was no evidence of a new wave of buyers flooding into the market, which puts this aspect of bubble formation into perspective.
Factor 4: Broad optimistic sentiment
The fourth factor in Dali’s “Bubble Gauge” is general market sentiment. During a bubble, there is often widespread optimism, with the majority of market participants believing that prices will continue to rise. In the first quarter of 2024, Dalio found that there was a clear bullish sentiment around AI investment, but not to an extent that could be considered excessive. In the third quarter of 2024, however, sentiment has changed. Market participants are increasingly talking about a “great rotation” and sentiment towards the Magnificent 7 has become much more skeptical, reducing the likelihood of a bubble in this area.
Factor 5: Purchases are heavily leveraged
The fifth factor relates to the degree to which purchases are leveraged. In a bubble, buyers often borrow heavily to acquire assets, which increases the risk of a market collapse when prices start to fall. In the first quarter of 2024, the volume of outstanding margin debt in the US had fallen to a 10-year low, suggesting that the markets were not overly reliant on debt financing. The picture is similar in the third quarter of 2024, as the level of debt remains low. This suggests that current purchases are not overly financed by borrowing, reducing the risk of a bubble.
Factor 6: Excessive forward buying and over-optimistic expectations
The final factor examines whether buyers or companies are making excessive forward purchases, i.e. whether they are betting heavily on future price increases by buying more than they currently need. In the first quarter of 2024, investment by the Magnificent 7 was at an all-time high, both as a proportion of their own sales and as a proportion of the economy as a whole. This indicated a certain degree of overheating, but not yet a clear bubble level. In the second quarter of 2024, this high level of capital expenditure continued, as shown by Alphabet’s huge capital expenditure of 13.2 billion dollars. These figures suggest that there is at least some “frothiness” (overheating) in terms of investment, but no clear bubble-like excesses yet.
Summary of the “Bubble Gauge” analysis
Based on the six factors of the Bubble Gauge, Dalio concluded in the first quarter of 2024 that the US equity market, including the Magnificent 7, has high valuations but is not clearly in a bubble. While the markets did show some overheated elements, overall conditions were not like those of past bubbles such as the 2000 dotcom bubble or the 2008 housing bubble.
However, the situation has evolved in the third quarter of 2024 due to the “great rotation” and increased selling in the markets. These changes could indicate that the markets are entering a correction phase rather than being in a bubble. Nevertheless, some uncertainty remains and the coming months may provide further clues as to whether the market is stabilizing or whether we may be approaching a major crisis after all.
Ray Dalio’s Bubble Gauge therefore provides a valuable tool for analyzing the current market situation. Even if it does not provide definitive answers, it enables investors to make a well-founded assessment of the risks and adjust their strategies accordingly. Developments over the next few quarters will show whether Dalio’s analysis remains valid or whether the markets are in a more dangerous situation than previously assumed.
Impact on the Crypto Market
Developments on the global equity markets, particularly the turmoil surrounding the Magnificent 7, have far-reaching implications for various asset classes, including the crypto market. Although cryptocurrencies and traditional equity markets have historically had a weak correlation, recent events in equity markets could have a significant impact on cryptocurrencies. To better understand this potential impact, it is important to take a closer look at the links and dynamics between these two markets.
The correlation between stock markets and cryptocurrencies
Historically, cryptocurrencies such as Bitcoin (BTC) and Ethereum (ETH) have often acted independently of traditional markets. This independence made them attractive to many investors looking for alternative investment opportunities. However, this dynamic has changed in recent years. With the entry of institutional investors into the crypto market and the growing acceptance of cryptocurrencies as an asset class, the correlation between equity and crypto markets has increased. This means that strong movements on the stock markets can increasingly influence the crypto market.
An example of this interaction was seen in July 2024, when the Magnificent 7 suffered a significant fall in value while the price of Bitcoin rose by 9%. This short-term rise in the price of Bitcoin could indicate that some investors are shifting capital from equities to cryptocurrencies in times of uncertainty. However, this rise was followed by a period of increased volatility and uncertainty, indicating that the crypto market is sensitive to major movements in traditional markets.
Impact of a possible bursting of the equity bubble on the crypto market
Should a potential bubble burst in the Magnificent 7 or the broader US stock market, this could have significant consequences for the crypto market. A sudden and massive drop in the value of major tech stocks could trigger a panic that spreads to other markets, including the crypto market. In such a situation, investors could sell their riskier assets, including cryptocurrencies, to cover losses in their traditional portfolios. This could lead to a sudden and sharp drop in crypto prices.
Another factor to consider is liquidity. If large parts of the market are affected by a sudden devaluation, liquidity shortages could arise, which would further increase volatility in the crypto market. As cryptocurrencies are often less liquid than traditional assets, price movements in these markets could be even more extreme, increasing the risk for investors.
The role of interest rate policy and its impact on crypto
Another important aspect influencing the relationship between the stock markets and the crypto market is the interest rate policy of central banks. The expectation of a rate cut in the US in September 2024, triggered by weaker inflation data in July, has led to a rebalancing of investment strategies. While this prospect could be positive for smaller companies and riskier assets such as cryptocurrencies in the short term, it also carries risks.
If interest rates are lowered, investors could move back into riskier assets such as cryptocurrencies, which could lead to short-term price rises. However, a sustained low interest rate policy could also lead to a bubble forming in these markets, similar to what happened with the Magnificent 7. Such a development could make the crypto market vulnerable to future corrections, especially if economic conditions change and central banks are forced to raise interest rates again.
Relevant article: Bitcoin price reacts to US labor market data and interest rate cut
Psychological Impact and Market Dynamics
In addition to the direct financial impact, investor psychology also plays a crucial role in market reactions. The recent losses in major technology stocks have stoked fears among many investors, which could also affect their investments in cryptocurrencies. In times of heightened uncertainty, investors tend to make risk-averse decisions, leading to a shift of capital from risky assets to safer havens. If this trend intensifies, the prices of cryptocurrencies could come under further pressure.
The volatility and uncertainty created by such market movements could also lead to an increase in speculative activity in the crypto market. As cryptocurrencies often fluctuate more than traditional assets, short-term traders may seek to profit from these movements, which could further fuel market volatility. This could in turn lead to increased risks for long-term investors who are unable to anticipate short-term fluctuations.
Conclusion: Uncertainty Remains
To summarize, developments in the global equity markets, particularly the Magnificent 7, could have a significant impact on the crypto market. While there could be a rotation of capital into cryptocurrencies in the short term, the risk of a major correction remains if equity markets come under further pressure. Investors in the crypto market should be aware of the increased risks posed by volatility and uncertainty in traditional markets and adjust their investment strategies accordingly. The next few months will show whether the crypto market is able to hold its own independently of developments on the equity markets or whether it will be pulled in the same direction as the traditional markets.
Conclusion and outlook
The current correction in the global financial markets could be the start of a major market reaction, or it could just be a healthy consolidation after a long period of growth. Although it is currently unclear whether we are in a bubble, investors should be cautious and aware of the risks associated with the extremely high valuations of the Magnificent 7 and the general market situation. Regardless of how the markets develop in the coming months, it will be crucial to rely on sound analysis and not fall into speculative exaggerations.
Author
Ed Prinz serves as Chairman of https://dltaustria.com, the most renowned non-profit organization in Austria specializing in blockchain technology. DLT Austria is actively involved in the education and promotion of the added value and application possibilities of distributed ledger technology. This is done through educational events, meetups, workshops and open discussions, all in voluntary collaboration with leading industry players.
Disclaimer
This is my personal opinion and not financial advice. For this reason, I cannot guarantee the accuracy of the information in this article. If you are unsure, you should consult a qualified advisor you trust. No guarantees or promises regarding profits are made in this article. All statements in this and other articles are my personal opinion.