How to Spot a Bubble: 2016 Edition

Posted by Brad McMillan, CFA, CAIA, MAI

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

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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.

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