Where’s the Next Bubble?

Bubbles can often mean trouble for investors. That means we are always on bubble watch. Fortunately, the current candidates do not seem to fit the classic bubble profile and may pose less potential damage to the broader markets and economy if they were to burst. The yield curve, which has done a good job of detecting when past bubbles are about to burst, bringing widespread negative consequences, also agrees on the relatively modest risk of a recession and bear market during the next twelve months. But that doesn’t mean these potential bubbles don’t carry risks for investors.

What’s a bubble?

Market bubbles have occurred across the globe and throughout history. In fact, the term “bubble” in reference to markets was coined in England nearly 300 years ago. An asset bubble is characterized by a wave of optimism that lifts prices beyond levels warranted by fundamentals and ends in a crash. Behavioral finance theory attributes bubbles to irrational investing behaviors characterized by groupthink and herd mentality. All it takes is a rising price on an overly optimistic outlook that gathers more followers as the trend is extrapolated into the future. The bubble bursts when the outlook is proven to be too optimistic, often after becoming the mainstream consensus.

Bubbles typically bring risks for all investors, even those that don’t own the inflating asset, because they represent a broader market and economy that has become out of balance and dependent upon a flawed outlook.

While sometimes only seen in hindsight, bubbles with potentially damaging impact on the broader markets and economy seem to have some similar characteristics which may enable us to spot them before they burst. As you can see in the chart below, these past bubbles inflated 1,000% over 10 years before bursting, cutting prices by more than half in the following two years. Examples of these types of asset bubbles that have burst over the past 20 years include:

• the technology, telecommunications and media stocks of the NASDAQ Composite Index,
• crude oil,
• precious metals,
• homebuilder stocks in the S&P 500 Homebuilding Index.

The 10 year buildup is important to how embedded the bubble becomes in the markets and economy when it bursts.

Bubble candidates

The four most popular candidates for bubbles based on the questions I get from investors are:

• cryptocurrencies,
• (low) volatility,
• internet retailers,
• central bank assets.

Remarkably, none of these seem to fit the classic profile of a potentially damaging bubble, but that doesn’t mean they don’t carry risks for investors.

Cryptocurrencies

The most popular cryptocurrency, bitcoin, has surged more than 1000%, but did so much faster than the bubbles that took 10 years to inflate to this level, as you can see in the chart below. The shorter amount of time that it took may mean that if bitcoin is a bubble and were to burst it probably won’t have as broad of a ripple effect on the economy as the technology or housing bubbles did.

Volatility

There are plenty of concerns that market volatility is too low and the global markets and economy have become increasingly dependent upon stable, rising prices that have become temporarily disconnected from political and fundamental risks. I disagree and wrote about it recently here: Is The Stock Market Just Quiet Or Is It Too Quiet?.

But there can be no doubt that stock market volatility in the world’s major markets is very low. And while many investments benefit from low volatility, there are specific products that are tied directly to volatility, some of which track the S&P 500 VIX Short-Term Futures Inverse Daily Index, which seeks to reflect the total return for those betting on low volatility for the S&P 500. This index has soared over 800% as it approaches 10 years from the end of the last bull market on October 9, 2007, as you can see in the chart below.

While the pattern seems to line up fairly well with prior bubbles, it would look different with a much larger rise and have more time to go until it reaches the 10 year time frame if I shifted the start date to the end of the bear market in March 2009, when volatility last peaked. Given that individual investors have only become net buyers of stocks in the past 9 months or so, according to the Investment Company Institute, it is possible that the low volatility and steady rise in the markets may have only started to draw more investors to stocks (from cash) and doesn’t yet reflect an overly optimistic outlook by investors that would constitute a typical bubble.

Internet retailers

Only in the past year have the stocks of the dotcom bubble measured by the NASDAQ Composite Index climbed back above their March 2000 peak. But a narrow sub-industry of internet stocks, internet retailers, is up well over 1,000% from the low in March 2009, as you can see in the chart below.

This small group of stocks make up a sub-industry of the retailing industry within the consumer discretionary sector, not a whole sector of the stock market (like technology) or the economy (like housing). The small size of this sub-industry relative to the overall stock market makes it difficult to label its growth a typical bubble and may limit the ripple effect on the broader market were it to crash. Unlike typical bubbles which tend to foster a purely optimistic outlook, these companies have already had a negative impact on the stocks of their traditional retail peers, leaving the overall retailing industry (composed of 10 sub-industries including internet retailers) up a smaller 500% over the same period.

Central bank assets

Sometimes investors stretch the definition of a bubble beyond asset prices and use the term to refer to central bank balance sheets bloated by years of buying through quantitative easing (QE) programs—suggesting they have the potential to burst and cause broad problems. The growth of the combined assets on the balance sheets of the world’s the major central banks (the Federal Reserve, European Central Bank, and Bank of Japan) have grown about 300% over the past 10 years, not the 1,000% of a typical bubble, as you can see in the chart below.

However, just because the assets on central bank balance sheets don’t constitute a classic bubble doesn’t mean total debt growth isn’t a problem. The relentless buildup of debt in the world economy doesn’t fit on a 10 year chart—it’s been growing a long, long time—and by well more than 1,000%. The amount of debt outstanding is huge and deeply embedded in the world economy (as are the assets it financed). However, the global buildup of debt most likely represents a long-term liability that threatens to exacerbate downturns, rather than a bubble about to burst.

Bubble vision

There don’t seem to be any classic bubbles near bursting at the moment—at least not among the ones most commonly referenced as potential candidates. But remember that bubbles are sometimes only seen in hindsight, which is why we always council diversification.

It is worth considering that bubbles may have evolved and the classic profile may no longer fit. Perhaps these days, an optimistic outlook can cause an asset price to rocket higher and become embedded into the mainstream more quickly than in the past, thanks to social media, more active investors, and the ability for a rapidly appreciating asset to stand out sharply in an overall environment of slow growth.

So we will keep watching, because while bubbles may change, they aren’t likely to go away.

 

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