Though there are those that are happy to take advantage of a stretched market and sentiment, there is a strong argument to be made that we are in the midst of a financial system-wide bubble. While it may continue to balloon for weeks or months, we should assess how popular assets would respond in the event that it pops.

Talking Points:

  • The global financial system is sporting a bubble built upon excess leverage and deep sense of complacency towards risk
  • While the areas and signifiers of excess are different today, there is a common thread in financial terms
  • We discuss how the collapse of confidence would impact global equities, major currencies, Bitcoin and VIX products

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It is difficult to argue against the prevalence of bubbles in the markets. Even speculative optimists can recognize the overuse of leverage, the extension of record highs without commensurate growth and yield, or the increasingly dubious explanations given to 'why we should invest now'. That said, recognition of a bubble does not call its end. The overindulgence can balloon for weeks longer and push market levels beyond bounds many would think feasible. I do not advocate capitulating and throwing in fully with an out-of-control market, but nor would I support building exposure to the opposite direction. Traders are opportunities and that often means suspending disbelief and personal measures of value to take advantage of sentiment. That said, we should always have a plan for scenarios that are increasingly likely and have a severe impact on price. And, the end to this daydream is far more likely than it has been at any point in the past years and there is significantly more to lose should it happen.

Perhaps one of best case studies in how a bubble collapse can impact a market are the major equity indexes. I focus in specific on the US-based S&P 500 and look back over the past 20 years where we have two very obvious such events. The Great Financial Crisis of 2008 and Dot-com boom and bust around 2000 were both clear and recognizable for many. There were different segments of the market that defined the extremes of each period (subprime housing and technology shares respectively), but the underlying driver was the same. There was a suspension of normal risk-reward considerations and use of financial leverage to gain exposure where tangible liquidity fell short. We have very much the same condition today - and the presence of central banks should not provide as much comfort as it currently affords. When markets turn, they often reverse the excess beyond 'fair value' and more - both because that fundamental measure drops and because fear creates a vicious momentum. Equities would likely suffer a steep and disruptive decline should the bubble pop, but it would eventually find stability. This is one of the most popular and accessible - not to mention regulator-favored - markets and therefore interest rushes in to fill voids.

Deep liquidity, however, is not a cure all against a retrenchment in the financial system. The benchmark currencies of the world have found much of their drive via rate speculation. Despite most of the major central banks' baseline yields hovering at or near record lows, there has been a blatant reach for 'pennies' in a bid to take advantage of 'others seeking higher returns'. Perhaps the best example of this FX-specific drive is the Euro which rallied through 2017 despite hosting a negative yield because anticipation for an eventual hike a year or more out as solidified. In the event of risk aversion, this stretch would be readily crushed. Yet, exchange rates do not have zero bounds but rather find equilibrium based on a host of factors including growth potential. The same is not necessarily true of the relatively new cryptocurrency market. Digital currencies like Bitcoin have not been accepted into the financial fold by regulators or consumers, but their promise and volatility have certainly drawn considerable speculative investment. For those investing in blockchain's future, there is an argument to weather a financial system storm, but for those merely looking to take advantage of momentum, a hasty exit is inevitable. What proportion of this market is speculator versus true long-haul believer?

Perhaps a more extreme example of speculative dominated market is the new volatility derivative products. Despite VIX sliding to a record low, interest in short volatility ETFs has hit a record high and net speculative interest in VIX future is still near record. The motivations and exposure of market participants here - not to mention what they have to lose - could lead to a sure end to assets like XIV. We discuss what happens to popular assets in the event our financial bubble pops and why certain assets will fare worse than others in today's Quick Take Video.

How Would the S&P 500, EUR/USD, Bitcoin and VIX Assets Weather a Bubble Pop?How Would the S&P 500, EUR/USD, Bitcoin and VIX Assets Weather a Bubble Pop?How Would the S&P 500, EUR/USD, Bitcoin and VIX Assets Weather a Bubble Pop?

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