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This article reviews the characteristics and different stages of a bubble…and identifies current conditions which match up with traditional bubble criteria. @A Financial Site For Sore Eyes & Inquisitive Minds
Bubble Characteristics
Some of the characteristics of past bubbles that should aid in identifying current potential asset bubbles include: @Economic Developments
- A failure to recognize that regular market participants are engaged in a speculative exercise which is not supported by previous valuation techniques. In sum, buying or holding the asset with little consideration for valuations.
- Suspension of disbelief by most participants (complacency).
- Unusual changes in valuation metrics or ratios relative to their historical levels.
- Elevated usage of debt (leverage) to purchase assets.
- Rationalizing asset prices by increasingly weaker arguments. In the past, these have included, “this time it’s different”, “the Fed won’t let asset prices fall”, “housing prices only go up.”
- Excessive risk taking.
- Extrapolation. This is projecting historical data into the future on the same basis (i.e.: if prices have risen at a certain rate in the past, they will continue to rise at that rate forever).
- A high presence of marketing or media coverage related to the asset.
Minsky’s 5 Stages of Bubble Activity
…Minsky identified the following 5 stages as a general pattern of bubble activity…@Follow the munKNEE
- Displacement: A displacement occurs when investors get enamored by a new paradigm. Recent examples include:
- innovative new technology (late 1990’s),
- rising home prices, which can never fall due to limited supply and growing demand for real estate (2000-2006),
- gold as the perfect hedge against the risk of a global financial crisis (2011),and
- central banks’ new ability to conduct indefinitely quantitative easing and asset purchases.
- Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, fearful of missing out. During this phase, the asset in question attracts widespread media coverage.
- Euphoria: Caution is thrown to the wind, as asset prices skyrocket. The “greater fool” theory plays out everywhere. We saw this in 1999/2000 with tech stocks, in 2002-2006 with real estate prices, and in 2008 with oil and alternative energy prices.
- Profit Taking: The smart money begins heeding the warning signs and is selling positions to take profits.
- Bust: Reality sets in, investors panic, and prices reverse course and descend faster than they increased…
Asset Bubbles Today
To begin looking for asset bubbles today, we must begin with those assets most impacted by central bank stimulus. They include rate products in developed countries and U.S. stock prices in particular. Reviewing the general characteristics of past bubbles, we can make a strong argument that several asset classes are already between the Boom and Euphoria phases of the bubble.
Consider the following:
- Suspension of disbelief by most participants (complacency). Everyone knows that the Federal Reserve will support asset prices and maintain a monetary policy favorable for equities. Most also believe that the Fed would alter policy in case of a drop in stock prices in order to prevent wealth destruction in investor portfolios (the Fed Put).
- Unusual changes in valuation metrics or ratios relative to their historical levels…
- A failure to recognize that regular market participants are engaged in a speculative exercise which is not supported by previous valuation techniques. Most readers know that fixed income investors have moved into the equity space to seek yield yet most do not understand the degree of speculation they are undertaking.
- Elevated usage of debt (leverage) to purchase assets. NYSE member firm margin debt balances as a percent of nominal GDP are back to levels seen in 2000.
- Rationalizing asset prices by increasingly weaker arguments. Who has not heard the following flimsy arguments to continue to hold equities today? :
- “As long as the Fed maintains low rates, valuations will remain attractive”
- “Companies have beat analysts’ estimates in the most recent earnings season” (conveniently forgetting that earnings…estimates are being revised down).
- “The U.S. economy is getting stronger.” (really?)
- Excessive risk taking. Yes, everywhere.
- A high presence of marketing or media coverage related to the asset…
- Extrapolation. Many market pundits are saying the bull market has another 6 months, 1 year, etc. to run. This is very helpful advice and should undoubtedly reassure investors that there is no need to sell any inflated assets.
- The smart money begins heeding the warning signs and selling positions in the profit taking phase….
Conclusion
In all cases, the hallmark of an asset bubble is irrational exuberance:
- an investor’s traditional methods of analysis and valuation are of little use,
- bubble assets are bought on both good news and bad news, on high valuations or on weak forward earnings guidance,
- trading an asset bubble, be it in Treasuries or in U.S. stocks, is very difficult (as seen above) due to the violent shake-outs in the Boom phase and risk of hitting the final air pocket in the Euphoria phase.
- [in previous bubbles] a reasonable investor could simply diversify investments to reduce exposure to bubbly assets, [but] today, in the “Everything Bubble”, this may be difficult.
There is no road map for how long or how high the Boom and Euphoria phases may last. It is laughable to read market pundits predict upside potential, both in terms of percentage gains and duration. Similarly, those warning of the impending bust of the Everything Bubble will be correct, but all traders know that being too early is indifferent from being wrong. Indeed, it is probably the most difficult time in recent history to invest, given the breadth of the Central Bank / Everything Asset Bubble — there are few places to hide.
Where are we now?
- Returning to Minsky’s five stages of a bubble, our best guess is that we are in the Profit-Taking phase given the high profile bearish calls of billionaire investors and record company insider selling.
- We have also had some violent shakeouts in U.S. equities… and Treasuries…suggesting that the Boom phase is well advanced and perhaps over.
How much longer and higher stocks and bonds may run in the Everything Bubble, no one can predict, but for those who stay invested in inflated assets, be aware that you are implicitly increasing your risk tolerance well beyond levels which typical risk-averse investors would be comfortable with.
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