In the US, another financial bubble is about to burst

The American stock markets might be broken and prone to a crash similar to the one we saw more than a decade ago

The deserted financial district amid coronavirus restrictions in New York City in March. Reuters

American stock markets have been disconnected from events for too long and a reckoning, which may come soon, is likely to burn those ordinary investors simply trying to grow their nest eggs.

It is a dangerous time. Despite the volatile and uncertain environment, US stock market indexes continued to climb following a short and sharp blip in February. After that, shares had their best period in more than 20 years in the second quarter.

Money is pouring into growth stocks like the big technology companies, a New York hedge fund owner told me, with little going the way of the "old economy". The millions of people in the US using the Robinhood app to invest for the first time in shares have also skewed the market.

All of this is related to the actions of the Federal Reserve, the central bank of the US, which has since March pumped trillions of dollars into securities to ensure that borrowing rates remain low and that there is enough liquidity in the financial system to give confidence to businesses and people to keep spending.

It seems, however, as if the rally has finally lost some momentum as the coronavirus pandemic has been gathering steam in the US with a spike in new infections. According to some opinion polls, Americans' confidence in the government's ability to handle the crisis - in areas such as getting children back to school - and the Fed's ability to handle the economy is weakening. The price of gold is up nearly 30 per cent this year, hitting another record this week. An investor friend of mine explained to me that this can be viewed as a sign of waning confidence in governments.

Still, a reckoning has been coming for some time, even before the coronavirus hit.

Under Jerome Powell, the Federal Reserve has pumped trillions of dollars into securities to ensure that borrowing rates remain low. Reuters

Nearly a year ago, Michael Burry, who made a fortune predicting the last financial crisis, as depicted in the film The Big Short, warned that the $4 trillion or so of passive money tracking American stock markets was creating a new bubble. The principles behind passive investing – which are sensible – are that over a long period of time you will get better returns by tracking an index, or an entire sector, rather than by trying to pick individual stocks. This strategy tries to account for the boom and bust cycle of markets.

But Mr Burry said in August 2019 that those people investing in tracker funds were not doing so based on the kind of "analysis that is required for true price discovery”; such analysis is based on using the future cash flow or current assets of a company to place a value on it.

Mr Burry warned that this was no longer happening and, as a result, huge amounts of money have been flowing into funds in an unsustainable manner, echoing what happened more than a decade ago when very risky assets became outlandishly popular with investors who didn't fully understand them.

When it came to light that they weren’t worth anywhere near the levels they had reached, it was a swift and brutal ride to the bottom for anyone holding the securities these assets were backing. Confidence evaporated.

Nearly a year ago, Michael Burry warned that the $4 trillion or so of passive money tracking US stock markets was creating a new bubble. AFP

Michael Burry has warned that huge amounts of money have been flowing into funds in an unsustainable manner, echoing what happened more than a decade ago

Today, the investors who use these low-cost and highly efficient passive strategies now make up nearly half of the money in US stocks and have become a risk to the system in recent years.

Yet the concern right now isn't just about how passive investors might impact markets. The broader worry is why American stocks remain attractive during the worst crisis in a century. It is frightening to consider that so much money is being put at risk like this when it is so obvious that there is a disconnect.

Yet, we are even more in the dark about what the true value of financial assets should be in July 2020 than we even were in 2008. The risk profile of US stocks cannot be accurately measured. There are too many unknowns about how the pandemic will unfold and what the actual impact will be on businesses and economies. What the share price of a company should be right now will be not much more than a guess. There should be a deep discount on share prices, not a premium.

At some point, investors will realise that current valuations do not match reality and the race for the exit will be far uglier than what we saw in the last financial crisis.

That awakening could come very soon too, with earnings season under way. We will gain some much-needed clarity about the scale of the damage that was wrought by the coronavirus on corporations in April, May and June, as well as receive some guidance about what the rest of the year could look like.

Confidence is a fragile thing. Once it is lost, getting it back is expensive and time-consuming.

The experience since the last financial crisis a decade ago is ample evidence of that, with central banks around the world unable to wind down their support without severe consequences.

Perhaps that is what many investors currently believe too, that they can always rely on the backing of the US government, no matter the events playing out on the ground, to keep stock markets chugging along.

Yet can the Fed step up its support from these already heady levels if there is another market crash? How long can it continue to pour trillions of dollars into the system after having done so for much of the past decade?

Even if it can meet such expectations, it might be too late by then for badly wounded investors.

Mustafa Alrawi is an assistant editor-in-chief at The National