If It Bleeds, It Leads
Talk of bubbles tends to captivate advisors, investors, and the financial media. This probably stems from two facts – one behavioral, the other quantitative. Behaviorally, most investors tend to be risk averse, and this doesn’t just mean that people don’t like to lose money. It means that for most investors, avoiding losses is more important than achieving gains – and “bubble” is a code word for “obvious mistake that costs you a lot of money.” No wonder investors’ ears perk up at the mention of a bubble.
On the quant side, while loss is always a possibility, security and asset prices tend to go up over time. Therefore, big price collapses are less likely and more non-consensus. That is, they are more provocative calls. Saying that stocks will fall 20% next year is a far more incendiary statement than saying they’ll rise 20%. Given that the industry is biased toward optimism (telling investors prices will fall tends to be bad for business), an accurate bearish call will put you in much more rarefied air than an accurate bullish call. As they say in the local news business, “if it bleeds, it leads.” Bubble talk makes great click-bait.
But a big problem with bubble talk is that no standard definition exists for exactly what a bubble is or isn’t. As bubble babble has increased in recent years, the term has become generalized to refer to any asset that is significantly overvalued. However, excessive valuation alone isn’t a high enough standard to warrant the bubble moniker. Yes, a bubble should offer the potential for significant losses, but even then, “significant” needs more detail. It probably should be a large negative outlier (say, -3 standard deviations) and should be relative to historical expectations. A 10% loss for stocks isn’t bubble-like but a 10% loss on high quality, short-term bonds could be. In the wake of the Great Financial Crisis, US home prices fell 20%–25%, qualifying for bubble status as home prices had never before fallen in unison across the country.
Besides the potential for big losses, a real bubble should demonstrate the definitional characteristics of a bubble. It should be inherently unstable. It should grow more fragile (yet more impressive) as it gets bigger, it should be easily popped (with the right argument), and the collapse should be swift – poof, and then gone. (Real bubbles don’t deflate slowly.) The best bubbles also have a flimsy rationale or dubious fundamentals along with some overcrowding, herding, and/or investor euphoria attached.
Having explained the allure of bubble talk and offered some evaluation criteria, here is our current bubble scorecard.
US Stocks – A bit expensive to be sure, but not bubblicious. By most measures, valuations are elevated, not extreme. Earnings are growing, albeit more slowly than forecast by our reckoning, and prices remain well-supported by super-accommodative monetary policy. Overseas, non-US equities and emerging markets look downright reasonably priced.
Tech Stocks – Yes, valuations look a bit expensive, and there are always some overhyped innovations. But this isn’t 1999. Today’s tech sector has viable business models and real earnings – even if those profits have been pushed further into the future. Moreover, the rush to become a more digital, social, and virtual world means non-tech corporate profits will continue to funnel into tech revenues for some time.
Sovereign Debt – Developed market sovereign yields are both historically low and arguably unsustainable relative to current growth rates. On the surface, very bubbly. But where is the pop? Rates are being actively suppressed by central banks, and we believe a dramatic leap in real rates (i.e., real growth) is unlikely. That leaves only a jump in inflation to pop the bond bubble, but few are forecasting that. Currently, deflationary forces seem to be winning the battle, further supporting bond prices, not undermining them. Bond prices may look bubble-ish, but we don’t see the fragility. Central banks will not allow rates to rise meaningfully, ensuring the stability of prices… at least for now.
Corporate Leverage – To be sure, corporate debt levels have risen significantly and credit quality has deteriorated. However, as rates have fallen, overall debt service cost has increased much more slowly. Moreover, Finance 101 reminds us that as yields fall, other things being equal, the optimal capital structure of a firm should have more debt. That is, some of the increase in leverage is justified. The question is whether firms have gone too far. For now, our concern remains that at some point, access to the capital markets – the ability to refinance maturing debt – becomes impaired. This is more worrisome than ongoing debt servicing. There are elements of bubble-like behavior here, but not a full-blown bubble in our view.
Private Equity & Unicorns – During this ultra-low rate environment with public equity valuations elevated, investors have poured into private equity (PE). Everyone is chasing the illiquidity premium. In addition to the capital they’ve allocated to PE deals, there remains over $2 trillion of unallocated capital, so-called “dry powder,” still waiting to be put to work. Classic bubble herding. However, some elements are missing. One, PE sponsor firms are naturally hesitant to lower appraised valuations, which enhances their resiliency and stickiness – at least on paper (the WeWork implosion being a notable exception). Two, the rationale driving the demand for private equity is legitimate, as rates are low and public market valuations are elevated. Undoubtedly there are bubbly pockets in PE – name by name, but it doesn’t appear to be a full-on bubble.
Cryptocurrency – The interminable gut-wrenching selloffs across many of the most popular cryptocurrencies clearly meet our bubble threshold statistically. Zero valuation support – check. Confusing rationale – check. HODLer1 euphoria – check. In the future, we expect cryptocurrencies will be developed with stronger financial backing and considerably less volatility. Cryptocurrency could also morph into a broader payment system. However, until that happens, cryptocurrency is always in bubble contention.
Passive Investing – From time to time we hear about the passive investing or index ETF bubble. As we have noted before, equity indexes tend to be more “top heavy” by market cap than most active managers. Because of this, we think the growth in passive investing will exacerbate the losses in the next cycle… a little bit. We also remain concerned about the liquidity mismatch of some ETFs vs. their underlying holdings, but this would likely cause only short-term dislocation. We doubt the growth of passive investing has created any systemic bubble.
The good news is that we don’t see the pop potential in many of the bubbles that the media and investors love to highlight. After a decade of rising stock and bond prices, there are bubble elements almost everywhere, but in most places, euphoria isn’t running rampant.
However, while we don’t see any blatant bubbles, at least not in the broad asset classes, cataloging this list of quasi-bubbles gives us pause. $17+ trillion in global quantitative easing has pushed valuations up, so few assets are cheap. Moreover, ongoing super-accommodative monetary policy has almost certainly created over-leveraged players and encouraged foolish behavior in some places and markets. $13 trillion in negative yielding sovereign debt makes it difficult to determine the risk-free rate. Recently, some “high yield” bonds in Europe traded at negative yields. Bubble or not, there are pockets of madness. Sometimes it all feels a bit artificial – living in this new world of distorted economic realities.
This brings us back to the abundance of quasi-bubbles and their potential correlation and spillover effects. Market information travels faster than ever, and strategies that de-risk (and re-risk) automatically have multiplied. Volatility begets volatility and liquidity is elusive. Strength in the US dollar spills over into commodities and emerging markets. US/China trade ripples morph into tsunamis for export-dependent economies like Germany and South Korea. Outside of a few weeks during earnings season, the markets are dominated by risk-on/risk-off trading.
Can we identify the obvious next bubble? No. But perhaps we can’t see the trees through the forest. Maybe it’s all one big bubble – the low yield/liquidity/correlation bubble? Until there is a shakeout, we remain cautious on risk assets as we see more opportunity for tricks than treats.
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