The Independent Market Observer

How to Spot a Bubble: 2016 Edition

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Jul 22, 2016 1:28:52 PM

and tagged Commentary

Leave a comment

bubbleIt’s been almost a year since I last wrote about investment bubbles. Although there have been ample grounds for discussing the topic, I suspect that other events have seemed more pressing.

It came to mind yesterday, though, when someone asked me about the housing market: was it back in a bubble? My answer was no, at a national level, although certain areas are showing distinctly bubble-like conditions.

That got me thinking. One of the characteristics of a bubble is that it makes some kind of sense at the time. Investors may look at it and think it odd, but at the moment, people mostly just go with it—housing in 2005, for example, or Internet stocks in 1998. Yes, things are pricey, but the trend is still solidly up, and perhaps things really are different this time?

You can keep pushing up prices for quite a while using that thought process.

Low interest rates and bubble potential

Thinking about it that way, what are we now looking at in the expectation that things could be different this time? I would argue that the key element is interest rates—and, from that foundation, we have a number of potential bubbles on our hands.

What are interest rates? Simply put, they’re the price of money. Based on basic supply and demand, low interest rates mean either a lack of demand for money or an excess supply of money.

Lack of demand isn’t the issue here—governments continue to borrow and run deficits—so the problem must be an excess supply of money. Clearly, there's lots of money chasing too few investment opportunities. Investors are bidding prices up, and interest rates down, in a quest to actually buy assets. We’ve seen this here in the U.S. recently.

With interest rates as low as they are—negative around the world and at unprecedented lows here—the question is why. Why will investors buy assets knowing, with mathematical certainty, that they will lose money over time if they hold them to maturity?

There are really only two explanations: (1) they are willing to take that loss for nonfinancial reasons, or (2) they believe that other investors will pay even higher prices and accept even lower, or more negative, interest rates later on. Buyers are either forced to buy for policy reasons or some other nonmarket factor, or they believe the trend will continue.

When prices rise for nonfundamental reasons

My definition of a bubble includes prices going up because of nonfundamental reasons, which is exactly what's happening with interest rates. Forced buyers in this case include central banks, pension funds, and insurance companies, which are driven by policy, not fundamentals. Traders are riding the trend and will be there until it changes, regardless of the fundamentals.

In other words, this is a momentum market that could change quite quickly—just like a bubble.

Interest rates matter because they provide the foundation for the value of every other financial asset. Stock prices, for example, are at historically high levels, and a big part of the justification for that is current low interest rates. Similarly, a big part of the housing recovery and affordability has come from inexpensive mortgage rates (although the effect of that has been mitigated by hard underwriting for borrowers).

The problem with policy-driven bubbles is that they are essentially unpredictable; they last until they change. Rather than take low rates for granted—maybe it is different this time!—we should be paying attention to the real possibility that, when policies change, we could be looking at one more popped bubble, with all of the consequences that implies.

  Subscribe to the Independent Market Observer

Subscribe via Email

Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®