Historically, rising volatility alongside increasing asset prices has been a clear indicator of an asset bubble. This phenomenon occurs due to factors such as asset prices decoupling from fundamentals and the fundamentals themselves becoming more uncertain.
Analyzing nine asset bubbles since the 1920s, analysts at Bank of America (NYSE:BAC) found that volatility increased in every instance ahead of the market peak.
Earlier this year, US equity momentum reached near 100-year highs, and the market was dominated by a select few US tech stocks, referred to as the "Magnificent 7." These stocks are collectively larger than the 2nd to 5th largest countries by market capitalization, prompting fears of a potential bubble.
However, BofA analysts note that the lack of a substantial rise in tech volatility indicates that the market has not yet reached bubble territory.
“Return dispersion (how much stocks diverge) also shows few bubble signs as do valuations compared to the late ‘90s,” analysts said in the note.
The real question, according to BofA, is whether AI can be incorporated into the economy without an asset bubble ensuing. The bank analysts believe this may be hard to avoid “given the likely significant but unclear way in which AI will impact the global economy, not dissimilar to the internet in the ‘90s or railroads in 1840s Britain.”
“The dominance of price momentum, investors remaining believers in buying equity dips, and meme stock popularity only add to the potential for irrationality,” they added.
Analysts also pointed out that the proportion of active equity risk originating from US tech stocks is at an all-time high, surpassing levels seen in the 2000s. If a bubble were to develop, this active risk would only increase. Simultaneously, stock fragility is reaching unprecedented levels, further complicating the management of active risk in today's market.