Amid Debates of Bond and Equity Values, What Constitutes a Bubble
- We can generally agree on bubbles after they've popped but a lack of clear definition makes them difficult to spot during one
- The most familiar bubbles through recent financial history are the Dot.com boom-bust in 2000 and housing bubble of 2007-8
- Common symptoms can help identify bubbles from supply-demand imbalance, diminished value concern and speculative concentration
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Former Fed Chairman Alan Greenspan took to the airwaves late this past week to speak to the levels of 'irrational exuberance' - a term he is well known for - that had evolved into a bond bubble in his view. The debate over whether extended trends from the likes of Treasuries and benchmark stock indexes constitutes 'bubbles' have been passionate and constant. Given that this discussion has continued with little sign of easing in intensity, it is fair to suggest that there is no commonly held definition of a bubble. The term itself denotes a market whose price (cost) has far outstripped its value and thereby is at serious risk of reversing. Yet, where there is general acceptance of that loose definition, there is very little agreement over what the metrics are for such a state which in turn makes the timing a point of constant speculative contention. While it is difficult to identify bubbles in advance and in the midst of their development, there is frequently more agreement after the fact. That can be useful to us.
The two most recognizable and least debatable bubbles of modern markets are the Dot.com boom and bust of 1990-2000 and the housing boom that crested in 2007-2008 which in turn predicated the Great Financial Crisis. From these periods of time, we can find similar symptoms which may speak to the measures of market imbalance that turn into bubbles. In the early evolution, an appetite for technology-specific assets (shares and derivatives) spoke to the rise of a new investor class that had the funds from a strong economic performance, the draw of performance that was unmistakable and a new phase of promotion for self-directed investing. For the successive bubble, hold over conditions (low rates) from the previous boom-bust promoted fevered investment with financial promotion directing to physical assets in the form of real estate. These seem different points of fixation; but ultimately, there are many points of similarity. In a practical sense, these was an abundance of leverage. The borrowed funds to employ to quick returns may have been directed to different asset classes; but ultimately, the speculative reach was the same.
Further, there is a progression of investor prioritization, comfort and exposure that predicates a situation that grows to unsustainable proportions. Much like the inflation we recognize with real-world goods (let's say a carry), there is a building imbalance of supply and demand. An appetite for something builds while its availability does not increase. That is as true for a financial asset as it is for an actual good. As liquidity diminishes and the recognition of others' appetite becomes clear, the consideration for the traditional yield or return for the asset evaporates. The dislocation of value in turn leads to greater debate over whether it is a good investment and what is motivating further evolution of the market's appreciation. That puts a market more firmly into the realm of speculation which draws market participants that value the hallmarks of quick return rather than durable investment. An appeal for quick and large returns rather than investment for duration and yield shifts the makeup of a market into the hands of 'traders' versus 'investors'. The former are sensitive to volatility and have little capacity for holding through pullbacks. That creates a market that exudes those characteristics of instability. And, see that imbalance an extended or richly priced market, the evolution can be the bubbles that we have seen in the past. So, are we seeing bubbles in the equity and bond markets today? Probably. But that doesn't mean that they have to implode in the immediate future.
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