After talking about where the bubble is and then Black Monday, there is something we must acknowledge: despite all the hand-wringing, the market is high and seems to be rising even further. Like the bumblebee— which, according to all sorts of sophisticated aerodynamic analysis, cannot fly—the market doesn’t know it can’t go higher and so it does.
I have gotten increasingly interested in this scenario as it relates to the mechanics of bubbles in general and, more specifically, what we need to watch for as this bubble matures. What can we learn about what got us here, and what can that tell us about what happens next? This was the subject of my Commonwealth National Conference talk, and I plan to spend the next couple of days walking through the argument here, going into a bit more depth than the speech allowed.
The fact is that the economy is doing quite well, and it has been for years. Ditto the market. Long periods of steady growth tend to breed complacency, as well as the expectation that growth will continue.
This idea was famously formalized by Hyman Minsky, the economist who pointed out that stability breeds instability. The longer things remain stable, the more chances people take, the more bad decisions build up, and the higher the house of cards grows. Once an inevitable shock finally hits? The longer the period of stability, the greater the ultimate damage. Paul McCulley of PIMCO coined the phrase the “Minsky moment” for when that shock does hit.
We are well into a period of stability right now, and you can see the incremental growth in risk taking. You can see it in low interest rate spreads, in loosening lending standards, and in higher prices for assets. Here, houses and stocks are two good examples. We have not had a real shock in some time, despite everything that has happened. Plus, the shocks that have come have been shrugged off.
Investors, having benefited in their own lives (with jobs and rising housing prices) and in their portfolios (with steadily rising stock prices), have internalized this complacency and have acted on it. Now, the perception is that the economy and market have largely been figured out. That after the last crash, we finally sorted out the problems. Note that I am not saying that this is the case. But speaking with clients, I hear a growing willingness to take risk that reflects a sense that a new crisis is unlikely. I now have many more conversations about clients who want to take on more risk than about those who refuse to take on any.
What we’re seeing now
This complacency generates its own set of behaviors, one of which is the steady progression of markets, with very little volatility. This is exactly what we’re seeing now. Beyond this, however, it is also intertwined with a couple of other meaningful trends that have combined to push markets higher, as well as reduce volatility even further, which only reinforces the base trend. Indeed, we will talk about those other trends. First, we should take a side trip into a different area, which we will look at tomorrow. Stay tuned!