Are We in a Bubble?

Last week’s post about the record high “Quit Rate” of American workers generated a fair amount of feedback. Some said “it’s about time” that workers finally gained some leverage over greedy employers, but the majority questioned the wisdom of workers flexing their bargaining muscles at this stage of the economic cycle. They said it was irrational exuberance at best, foolhardy at worst, particularly for younger workers who haven’t been through a full economic cycle before.

Speaking of irrational exuberance, several of our clients have been interviewed in the national media

about whether our economy and financial markets are heading into bubble territory.

Dr. Guy Baker, CFP, Ph.D founder of Wealth Teams Alliance (Irvine, CA) said a bubble occurs whenever one sector of the economy is doing much better than would be expected if it were not for a few specific factors in play. “The dot-com boom became hyperextended because more and more dollars were flowing into companies that had no viable economic record,” added Baker a member of the Forbes 250 Top Financial Security Professionals List and author of The Great Wealth Erosion, Manage Markets, Not Stocks and Investment Alchemy. “The gold rush mentality drove the urgency to not lose out. As a result, the value of Internet companies soared and became a bubble,” observed Baker. “When the bubble popped, only the strong survived. When we look at bubble thinking today, the only real bubble driven by economics is cryptocurrency,” he added.

Regulatory bubble

While some readers also pointed to meme stocks like GameStop, non-fungible tokens and the boom in SPACs, Baker said he is more worried about another type of bubble that most folks aren’t paying attention to – the government regulation bubble. “We saw this in 2009-2010 when the government caused disfunction in the mortgage market,” explained Baker. “Homebuyers were able to qualify for mortgages based on nothing more than their signature and a statement of ‘fact.’ The free money came home to roost when the economy slipped, and these homeowners walked away from the houses leaving the lenders with an empty house and an inflated value,” he added.

Baker maintains that economic bubbles are part of the capitalistic system, and usually isolated to the companies affected, but regulatory bubbles are not. “They are dangerous and can cause huge damage to institutions and businesses,” he added.

So, how can investors protect themselves from speculative investments related to economic bubbles?

The best way to protect yourself is through wide diversification, advised Baker, adding that in a “well-balanced, smart portfolio” most of the companies that would be “disasters when a bubble burst” will not be included in the mix. He prefers ETFs and mutual funds that are well diversified. “It’s important not to buy funds that do the same thing,” said Baker. “Also, stay away from funds that say one thing and do another. Low turnover is a key metric to watch. Low turnover means the portfolio managers are making good choices and sticking with them. High turnover suggests the fund is chasing yield.”

Five stages of an economic bubble

In his landmark book Stabilizing an Unstable Economy (1986), economist Hyman Minsky identified five stages in a typical credit cycle which follow the typical stages of an economic bubble:

1. Displacement. Investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low.

2. Boom. The asset in question attracts widespread media coverage. Fear of missing out (FOMO) on what could be a once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of investors and traders into the fold.

3. Euphoria. Caution is thrown to the wind, as asset prices skyrocket. Valuations reach extreme levels during this phase as new valuation measures and metrics are touted to justify the relentless rise. The "greater fool" theory plays out—the idea that no matter how prices go, there will always be a market of buyers willing to pay more.

4. Profit-Taking. Believing the bubble is about to burst, the smart money starts selling positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise.

5. Panic. It only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot b reinflated. In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate at any price. As supply overwhelms demand, asset prices slide sharply. Think the early days of COVID or the 2008-09 global financial crisis.

Most think we’re somewhere between Euphoria and Profit-Taking. But, as economist John Maynard Keynes famously said: "the markets can stay irrational longer than you can stay solvent."

 

What’s your take? I’d like to hear from you.

 

Conclusion

 

As billionaire value investor, Seth Klarman likes to say: “At the root of all financial bubbles is a good idea carried to excess.” Or as Warren Buffett always says: “Be fearful when people are greedy and be greedy when people are fearful.” I’m not sure whether we’re in a bubble or not, but like most things in life, the truth usually lies somewhere between the extremes.

#economicbubble, #irrationalexuberance, #investing, #diversification