Sector size and equity bubbles

 

The FT provided an interesting bubble chart on the size of the IT sector relative to the US markets and the rest of the world. Of course, we have been following the size of the Mag 7 relative to the rest of the SPY over the last year, but the size of the IT sector versus the rest of the world is crazy and suggests that the market is overvalued and in a bubble. Just look at the difference in size for the IT sector between 2010 and 2025 with the rest of the world.

There we go again with that term - bubble. The term is thrown around yet saying that a market or stock is in a bubble does not provide any action plan for what to do. The IT is larger, but what is the appropriate size? IT is clearly more important to the world economy today than in 2010, yet should it be larger than the market cap of the UK, Japan, and China combined? IT is changing the world, but how should this be valued as discounted future cash flows. 

One can avoid these markets and stocks but there is a strong opportunity cost. You will miss the sizable move and be out of balance with a market weighted portfolio. If you are a passive index holder, you are riding the bubble, so if you want to avoid, you will have to drop these market-weighted indices. Shorting is an alternative, but the pain until a crash is high and no one knows when a crash will occur. So, is it just a game of watching? 

Market efficiency and financial crises

 

An older paper has come across my desk as a good review of the history of the efficient markets hypothesis (EMH) as well as   a novel view about how the EMH fit within a world with pricing bubbles, see Stephen Brown in the "The Efficient Markets Hypothesis: the Demise of the Demon of Choice".

Brown provides a good explanation of the foundations in the EMH along with the fact that most practitioners do not believe in the efficient markets hypothesis. Nevertheless, even though the EMH may. to be true, it may be important for many to believe that it is close to truth. Many will lose money attempting to prove the EMH to be false. Because there is this lack of belief in the EMH, many traders will take more risk and use more leverage than they should. Of course, when a crisis comes there will be greater loses and many traders are on the wrong side of the market.

NYFed MCT suggests further persistence

The NYFed developed the multivariate Core Trend (MCT) model for PCE inflation to look at the persistence or trend of inflation components in the PCE. It tracks the PCE closely and explains why the Fed believed that inflation would not be persistent during 2022. The MCT numbers did not suggest that the components would persist. The PCE moved back to the longer-term MCT, yet the current data tells a story that the Fed is not winning the war on inflation. Inflation seems to be stuck just below the 3% level. By this measure, we are unlikely to see the Fed come close to the 2% target.  

Follow the liberal arts to be a good analyst

Debate logic with your acquaintances, And practice rhetoric in your common talk; Use music and poetry to quicken your mind; Turn to mathematics and metaphysics when you can stomach it. 

- TheTaming of the the Shrew 

To be a good analyst you need more than just math and quant skills. You also need more that finance knowledge. You need to have a complete set of skills that mixes logic, rhetoric, and math. All have to be practiced on a regular basis to be part of your everyday thinking.