An import facet of investing is being able to recognize early on when an asset price moves into a bubble phase. A bubble may be broadly defined as"investors bidding up the price beyond any real sustainable value". In such conditions, an investor's approach to analyzing the asset, as well as risk tolerance, must change. Notably, Benjamin Graham's classic definition of investing("An investment operation which, upon thorough analysis, promises safety of principal and a satisfactory return") no longer applies once an asset price enters a bubble. In a bubble, we move from the realm of investing to the realm of speculation, and investors must therefore consciously adapt their analysis and portfolio risk levels.
In this Commentary, we review the characteristics and different stages of a bubble, present some recent asset price bubbles, and identify current conditions which match up with traditional bubble criteria.
Some of the characteristics of past bubbles that should aid in identifying current potential asset bubbles include:
- 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 (ie: 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.
Below we will demonstrate how many of these characteristics reflect various asset prices today. To conclude this section, we reflect on Hyman Minsky's theory of financial instability, which gained in popularity after the Financial Crisis. Minsky identified the following five stages as a general pattern of bubble activity. We add a couple examples from recent financial asset bubbles, which we review in the last section.
- 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),*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.
Recent Cases of Asset Bubbles
Let's look at how the above bubble characteristics and stages were manifest in recent prior bubbles.
Japanese Asset Price Bubble (1986-1991)
Japan's bubble was characterized by rapid acceleration of real estate prices (and subsequently stock prices) and an overheated economy. All of this was fueled by a Bank of Japan monetary policy errour, lowering interest rates and allowing uncontrolled money supply and credit expansion. The euphoria phase was characterized by Japanese citizens, traditionally great deposit savers, shifting money from savings accounts into the capital market. On our chart of the Nikkei 225 stock index, several items are worth noting:
- The Boom phase contained several violent shake-outs before almost all economic actors moved their money into the capital markets during the Euphoria phase in 1989-90.
- Valuations become detached from underlying fundamentals, with Japanese stocks trading at nearly 100 time earnings.
- During the bust phase, we see a strong attempted rebound before these hopeful dip-buyers are blown away by another rapid downdraft.
- Finally, for those who bought at the top, it is now 26-years and counting that these investors have waited to get back to their purchase price.
The Dot-Com Bubble (1995-2000)
We see most of the bubble characteristics cited above with the tech stocks during this period. Our chart of the Nasdaq-100 (NASDAQ:QQQ) again shows:
- Excessive valuations, as investors enthusiastically bought tech stocks without considering valuation.
- During the bust phase, we again see a strong rally attempt fail.
- For those who bought at the top, it was over a 16-year wait to recover their investment. Needless to say, most investors sold out or passed away before this year's return of the Nasdaq to 2000 highs.
China Stock and Property Bubble (2007)
Chinese stock prices ran up from 2006 to 2007 on speculative trading with borrowed money (the leverage quality of bubbles). In the chart of the CSI 300 index (NYSEARCA:ASHR) below, the same themes reappear:
- The Boom phase contained several violent shake-outs before everyone believed in the rally as the bubble entered the Euphoria phase.
- Valuations become excessive, but investors were not interested in P/Es.
- During the bust phase, we see a strong rebound that is stopped by overhang in the market as prices neared the bubble peak.
- Finally, for those who bought at the top, it is now 10-years and counting.
Crude Oil Bubble (2008)
Remember "Peak Oil"? This was the cause, or the displacement, which began the oil price bubble starting in the summer of 2008. Investors got out of the stock market in 2007 and started investing in oil believing that demand from China would outstrip supply. Oil prices (NYSEARCA:USO) set a record of $143.68 a barrel in July 2008 before collapsing to $33 a barrel six months later. Same pattern in the chart below:
- The Boom phase contained several violent shake-outs before traders moved massively into oil contracts during the Euphoria phase in the summer of 2008.
- During the bust phase, we got a nice rebound to short (or escape, for late long positions).
- Eight years later, we still have not seen the $200 / barrel oil prices Goldman Sachs promised us.
United States Housing Bubble (2004-2007)
Mortgage-backed securities insured by credit default swaps allowed banks and mortgage brokers to offer home loans to just about anyone. That drove up demand for housing, which homebuilders tried to meet. Many people bought homes, not to live in them or even rent them, but just as investments to sell as prices kept rising. Home prices never fall, we believed, creating the displacement which led to the housing bubble. Looking at the Dow Jones Homebuilder's index (BATS:ITB), we once again see the same bubble characteristics:
- The Boom phase contained several violent shake-outs in homebuilder stocks before everyone wanted to be a homeowner during the Euphoria phase in 2005/2006.
- Valuations of homebuilders became ridiculous, but no one cared since home prices always rise.
- During the bust phase, we see an attempted rebound, the last chance to get out, before homebuilder stock prices proceeded to lose -80%.
- Finally, for those who bought at the top, it is now 11-years and counting that these investors have waited to get back to their purchase price.
Clean Energy Bubble (2006-2008)
Going hand-in-hand with the "Peak Energy" speculation, investors fell in love with solar, wind, and other forms of clean energy (the displacement). Never mind that these companies never earned money and survived only through heavy government subsidies. As with the prior bubbles:
- The Boom phase contained several violent shake-outs in 2006 and 2007 before the Euphoria phase in 2008.
- Valuations of alternative energy companies became senseless, but no one cared as the Peak Energy story was a seducing sell.
- During the bust phase, we see the ubiquitous last chance rebound, before -75% losses.
- Finally, for those who bought at the top, it is now 8-years and counting with little hope for these investors to get back to their purchase price.
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 favourable 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. Many have noted how several U.S. sectors [notably the high dividend paying Utilities (NYSEARCA:XLU) and Consumer Staples] are trading at valuations 3 standard deviations above historical norms. The Russell 2000 (NYSEARCA:IWM) is trading at the absurd height of 85x reported earnings. Yet these facts don't seem particularly concerning to most investors.
- 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 have contracted five straight quarters and forward 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. The media recently celebrated the Triple Record Highs on the Dow, S&P 500, and Nasdaq.
- 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. We recently reported company CEOs began selling their company stock at a record pace in July. Prominent billionaire investors such as George Soros are short the S&P 500 (NYSEARCA:SPY).
A couple quick examples of assets we believe to be close to the Euphoria stage of a bubble. The top chart shows the S&P 500 Consumer Staples index (NYSEARCA:XLP) and the bottom chart the Treasury Bond ETF (NYSEARCA:TLT).
In all cases, the hallmark of an asset bubble is irrational exuberance. As such, 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. Moreover, trading an asset bubble, be it in Treasurys 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. While in prior bubbles, a reasonable investor could simply diversify investments to reduce exposure to bubbly assets, 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 (Oct. 2014 ; Aug. 2015 ; Jan. 2016) and Treasurys (Summer 2013 ; Spring 2015) 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.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.