What Are Market Bubbles? [And How to Identify Them]

We’re in a zero interest rate world, which is the most important theme currently governing financial markets and has big implications for portfolio construction.

By extension, this means we’re in a period where the forward returns of financial assets will be low across the board. While this support is necessary, it makes markets susceptible to bubbles.

In the developed world, cash rates are zero practically everywhere you go. In some places (e.g., EU, Japan), they’re negative. In the US, some parts of the curve briefly went negative, anticipating that the US could be forced to go this route as well.

Bonds of longer duration are also at or around zero as well.

The “yield” on stocks is more difficult to determine because they don’t come with advertised rates like cash and bonds do.

Stocks convey ownership of a business that represents a residual value after everyone else has been paid. They’re perpetual cash flow instruments, so their structural volatility is higher.

What we do know is that stocks historically, over the past 50 years or so, have had an extra 2 to 3 percent annual return over 10-year Treasury bonds.

So, if mid-duration “safe assets” yield 50bps or less, there’s very little to no discount rate. The value of a business is simply the amount of cash you can earn from it over its life discounted back to the present.

Accordingly, if there’s no discount rate – i.e., the rate off which the present value of future cash flows can be calculated to get its fundamental value – then you’re just left with the risk premium (traditionally that 2-3 percent).

The inverse of that 2-3 percent represents the price-earnings ratio, or about 33x to 50x (1 divided by .03 and 1 divided by .02, respectively).

That means traditional markers of value, like the 10x to 20x P/E ratios that investors have become used to are extrapolations of a previous environment in which yields were much higher.

For example, in an environment where the cash yield is 5 percent, mid-duration safe bonds give you 7 percent, stocks would typically yield around 10 percent (10x P/E), keeping in line with the typical risk premiums.

If cash and bonds are now at zero yields, and stocks keep that same 3.0-3.5 percent premium, your P/E is now 3x to 4x higher.

That means what formerly might have been a $10 billion market cap company is now a $30-$40 billion market cap off the same earnings.

All assets compete with each other, and once other assets get bid up, others look more attractive in relative terms even if the risk in absolute terms remains the same.

Even if the forward returns on stocks are about 3 percent in developed markets going forward instead of the 5-12 percent in recent history going back decades, the risk is still the same.

And there are also other issues to worry about, such as geopolitical conflict and the dollar’s reserve status.

And while asset returns could still be okay in nominal terms, that doesn’t necessarily mean they’ll be good in real terms. And they’re quite unlikely to be due to low productivity growth and aging populations.

When the returns of riskier or higher duration assets get down to close to zero, then it increasingly no longer makes sense to own them.

For example, if the 10-year yield is 100bps, and your upside is the yield going down to minus-100bps and your downside is a normalization in real rates plus an inflation rate of 4 percent, your risk is about 3x your potential reward.

So, cash doesn’t return anything. It is safe in the sense that its value doesn’t change much.

But it’s the worst thing over the long-run due to inflation and any taxes on the yield.

Then bonds don’t yield much or anything at all (and negatively in real terms), plus have price movement providing mark-to-market risk.

That gets more capital into stocks, bending those yields down to cash and bond rates and inflating their multiples on earnings.

Here are forward nominal return estimations for US assets (early-2021 estimates). The figures on the right show risk premiums (“RP”) between different asset classes.

But let’s back up a bit first and describe the bubble phase, the warning signs of a bubble, and the lead-up to a bubble.

Developed market bubble vs. Emerging market bubbles

Emerging Markets

We published a series on trading the cycle in emerging markets.

The types of recessions we see in emerging markets are different from those in developed markets.

Broadly speaking, developed markets are countries with:

• reserve currencies
• stable political environments
• developed capital markets (debt and equity)
• strong rule of law
• respect for private property rights, among other markers.

Emerging market recessions tend to be inflationary while developed market ones tend to be deflationary.

This is because of the effect of the currency dynamic.

Emerging markets tend to borrow in other countries’ currencies. When a recession hits and the currency declines relative to the one they borrow in, that’s like a big surge in interest rates.

Printing money to make up for the shortfall worsens the depreciation, which increases the costs of imports and typically leads to a contraction in supply relative to demand, pushing up the prices of goods and services (i.e., inflation).

Developed Markets

On the other hand, in developed markets, recessions tend to be deflationary.

They heavily borrow in their own currencies, so they avoid the FX risk. When a downturn occurs, debt servicing exceeds income. Spending must be cut back, which is deflationary.

Countries that can “print” money will try to do so to offset the drop in credit.

Countries that can’t print money, or can only do so to an insufficient extent because they lack reserve currencies, will need to restructure their debts.

The bull market

In the early part of the cycle, incomes are growing faster than debt. Debt growth is robust, but still lower than income.

In the early stages of bull markets, there is a wide range of productive investments. So even though debt growth is strong, it’s used productively to produce income in excess of the debt.

If money is borrowed and it makes a business more productive by providing goods and services that provide value and grow revenue commensurate with such value, then debt burdens will remain low and balance sheets will remain healthy.

Given such an environment with quality forward returns, there is enough room for the private sector, financial system, and government to lever up.

When inflation is a reasonably low and stable percentage and debt growth is below or in line with income growth, this is a quality period for investments and justifiably produces a bull market.

The bubble phase

The bubble phase begins when debt growth is faster than income growth.

This is when debt produces income less than the sum of principal and interest payments. The debt growth becomes unproductive.

Yet rising debt growth still produces strong returns in assets, income, and overall economic growth. The price of financial assets is a function of money and credit spent divided by their quantity.

Even if the debt being produced doesn’t throw off the cash flow to make these debts viable, there’s a tendency to extrapolate the past and assume it’ll be like the future even when the underlying conditions change.

Higher debt produces rising net worths, incomes, and asset values. This perpetuates the process as borrowers become more creditworthy.

Creditworthiness is a function of:

i) income and projected cash flow available (or likely to be available) to service the debt

ii) existing savings and net worth or available collateral

iii) their own capacity to lend capital (i.e., for banks, fintech, non-bank lenders, hedge funds, etc.)

All of these factors rise in tandem.

Borrowers will feel wealthier even when the underlying state of conditions changes from the “healthy bull market” phase to the “bubble” phase.

Debt growth is exceeding income growth yet they continue to buy assets at high prices on credit.

For example, assume someone makes $100k per year and has a net worth of $100k.

Let’s say they could borrow up to $10k per year, which means they could spend $110k per year for several years even though their annual income is only $100k.

This increased capacity for borrowing allows for higher spending and a person’s spending can lead to higher income, higher asset valuations, and/or higher savings. This, in turn, gives them even more collateral to borrow against.

This causes people to borrow more and more, with this process quickly starting to resemble a cycle. When people borrow, they are not only borrowing from a lender, they are borrowing from their future self.

Eventually they have to spend less, invest less, and/or take less for themselves because they have to pay that money back.

But so long as that borrowing helps drive economic growth and it produces more income in excess of the servicing, it’s affordable.

In the upswing in the debt cycle, the promises to deliver money (namely, debt burdens) rise relative to the money supply, economic growth, and all forms of liquidity available to borrowers to pay back their obligations (which come from incomes, new borrowing, and asset sales).

Over the years, central banks periodically adjust short-term interest rates to slow down or help pick up the rate of credit creation. This is the standard business cycle that most of us are used to and experience multiple times over the course of our lifetimes.

Many business cycles add up to a longer term debt cycle that ends when short-term interest rates hit zero.

Since the early 1980s in the developed world, interest rates have been in secular decline. Central banks have managed several business cycles during this period.

But each cyclical peak and cyclical trough has been lower than the past.

(Source: St. Louis Federal Reserve)

Lowering interest rates increases the demand for debt and it also raises asset prices and people’s wealth (through the present value effect in terms of what lowering interest rates does to increase asset prices).

Generally, this creates progressively higher debt levels relative to income and reduces the capacity to raise interest rates without triggering an intolerable drawdown in the economy.

Eventually, short-term interest rates hit zero and the capacity to push credit creation further can’t go on.

While the business cycle that we’re used to ends whenever the central bank hikes interest too far (usually to rein in inflation), the longer term debt cycle ends when rates hit zero or a bit below zero and can’t be pushed down further.

The hitting of the zero lower bound usually occurs when:

i) debts become too large relative to the amounts that can be borrowed, and

ii) the debts become too large in relation to the money in existence

When the amount of money and credit coming in can’t rise relative to the need to service debt, the process works in reverse.

Investors need to deleverage, borrowers default, creditors pull back lending, and the down part of the cycle beings.

Borrowing is a way of pulling forward spending. The person who spent $110k per year and was earning $100k per year now has to spend $90k per year for as many years as he spent $110k per year, holding all else equal.

This is the general dynamic that inflates and deflates a bubble.

How Bubbles Start

Bubbles typically begin as excessive extrapolations of justified bull markets.

Bull markets are justified when interest rates (i.e., cash rates) are low relative to the returns on stocks, credit, real estate, and other equity investments.

When they go up, economic conditions improve as people become wealthier, companies hire more, corporate profits increase, which improves their balance sheets and ability to take on more debt. All of these influences cause companies to be worth more.

When asset prices go up, spending and incomes rise, as do net worths.

Business people, investors, banks and other financial intermediaries, and policymakers have more confidence in ongoing prosperity. This causes leverage in the system to increase.

The boom also encourages new speculative flows from new investors who fear missing out on the gains. This fuels the bubble further.

Anywhere from “sometimes” to “frequently”, governments adopt policies that encourage banks and other financial intermediaries to lend to those who are unlikely to represent profitable lending opportunities.

This encourages reckless lending and a buildup of bad debt within the system.

Credit standards being lowered are one of the hallmarks of a justifiable bull market turning into a bubble.

With new lenders and new speculators in the market, new types of unregulated investment vehicles develop. Non-bank lenders are collectively called the “shadow banking” system, which are also not subject to the same government protections.

New lending vehicles are commonly created (e.g., peer to peer lending) and financial engineering occurs to generate higher prospective returns.

Lenders and speculators typically make a lot of money quickly.

This helps reinforce the bubble as higher net worths helps secure new or larger loans to buy even more assets.

While this is going on, most don’t believe it’s a problem.

People like it because they’re getting richer or, from the outside, view it as a positive. Most assume it’s a productivity-driven boom. In turn, this causes the rise to feed off itself.

With stocks and other risk assets, rising prices leads to more investment and spending. This raises earnings, which in turn increases asset prices further.

This narrows credit spreads and incentivizes more lending due to higher earnings and more valuable collateral, which increasing investment and spending, in a self-perpetuating cycle.

Most people think the assets they’re buying are great to own and anyone who doesn’t is missing out.

So, all sorts of entities (institutions, retail, banks, etc.) build up long exposure to these assets.

Asset-liability mismatches increase in various forms:

i) increasing liquid liabilities to invest in illiquid assets

ii) borrowing short-term securities to invest in more volatile, longer duration assets

iii) carry trade exposure increases, such as borrowing in one currency to buy another that yields more

iv) borrowing money from other people to invest in risky forms of debt and equity

All fundamentally rely on chasing some type of spread between prospective returns and the borrowing rate.

However, as asset prices are bid up, this narrows the spread. Typically, capital market participants will increase their leverage to achieve the desired return on equity, building further leverage into the system.

Debts rise and debt servicing costs typically increase even faster.

On top of all this, while the central bank is mostly concerned about inflation in goods and services, the inflation in financial assets is actually more insidious.

While goods and services inflation is viewed as a bad thing because it increases the cost of living and creates lower disposable income at a certain point, financial asset inflation appears like a good thing and it isn’t prevented.

However, it’s just as bad as any other form of indebtedness.

A financial asset represents a securitization of a cash flow. In order for the asset to justify its valuation, it has to earn that income to give you the earnings or cash flow you’re entitled to.

But if booms are an effect of debt rather than productivity and not enough income is produced from this debt, asset prices become out of whack relative to the practical level of earnings they can generate.

Moreover, financial booms financed by debt typically come alongside periods of low inflation (often because low interest rates go hand in hand with low inflation, which incentive borrowing), even though they appear to be driven by productivity gains.

This was true in much of the developed world in the 1920s leading up to the 1929 bust, Japan in the late 1980s, and most of the world in the mid-2000s leading to the 2007-09 financial crisis.

The overweighting and extrapolation of recent history

Markets are discounting mechanisms where they price in a weighted average of all opinions called a consensus.

This is generally considered a reasonable picture of what’s likely to happen even though the future is typically different from the past.

Humans tend to follow the crowd and emphasize recent experiences.

For example, asset prices going up often makes them seem like better investments rather than worse investments.

Though if we follow common behavioral patterns when it comes to a consumer good, a rising price typically makes us less likely to purchase it, not more likely.

Because the consensus is always priced in based on the capital flows that created those prices, inappropriate extrapolations of the past tend to occur.

At these periods, debts relative to income tend to rise very rapidly.

Bubbles are likely to occur near the top in the various cycles, whether this is the business cycle, longer-term debt cycle (i.e., when interest rates hit zero), and/or the balance of payments cycle (more common for emerging markets).

When the bubble nears its top, there are the conflicting elements of the economy being the most vulnerable at the same time people feel the wealthiest and most bullish.

Debt to income ratios commonly average around 300 percent of GDP at the peak and is generally accompanied by a flattening yield curve (i.e., long-term interest rates coming down to short-term interest rates).

Monetary policy’s role

Oftentimes, monetary policy helps inflate the bubble rather than reel it in.

This is particularly true when inflation is modest and within acceptable limits, growth is at around expectations, and the returns on investment assets are solid.

This helps reinforce the optimism driving investors to buy financial assets on leverage.

Because central banks have statutory mandates to focus on limited frameworks (inflation or inflation and growth), and not credit growth, they often don’t adequately tighten policy. This was responsible for Japan’s market dynamics in the late 1980s.

Looking at averages also tends to skew important variations around those averages within key parts of the economy.

Nikkei 225 Chart, 1984 to the present

(Source: Trading View)

It was also true for housing in the mid-2000s.

The flaws in central bank policies often lead to these problems in the first place.

Central banks typically target a mandate of either:

a) inflation (i.e., price stability) or

b) inflation and growth (full employment within the context of price stability)

The implication is that they typically don’t place much attention on the debt growth that’s occurring to finance the creation of bubbles.

If growth and inflation don’t appear to be strong or the central bank is actively stimulating the economy, this can facilitate excess speculation in the financial economy with the hopes that some of that wealth creation will eventually get into the real economy.

However, a central bank is heavily responsible for all debt in an economy given their pulling on their levers influences incentives.

It’s important for them to keep debt growth at a reasonable level with a focus on keeping it neither too high nor too low relative to income (i.e., such that it can be serviced).

Some policymakers will counter this point saying that it is too difficult to ascertain whether a bubble is occurring, that “engineering” the financial markets is beyond their scope or duty, and that growth and inflation is their given mandate.

However, they do control the amount of money and credit in an economy.

When that money and credit goes into debts that cannot be paid back or into risky assets whose earnings will never justify their valuations, that has big implications for growth and inflation down the line.

The biggest depressions occur when bubbles burst (e.g., 1929, 2008). If central banks are the ones producing the debt that are inflating these bubbles and they won’t control them, then the question becomes who will control them?

The economic pain of a 1929 or 2008 or the various bubbles throughout history is so high (and changes the economic, social, and political landscape of a country) that it is not sensible for central bankers to ignore them.

This is why a “credit growth in line with income growth” mandate is so important rather than merely managing the business cycle, or the trade-off between employment and inflation.

When inflation runs above an acceptable level, it’s common for central bankers to raise short-term interest rates. But normal monetary policies of short-term rate adjustments are largely too broad and non-specific to sufficiently manage bubbles.

This is because bubbles often manifest in certain parts of an economy and not in others.

For example, in the 1998-2000 period, it occurred in technology and internet companies. From 2004-08, residential housing became a problem.

Basic short-term interest rate adjustments are not usually appropriate for some sectors relative to others.

During this time, central banks are likely to fall behind the curve. Some borrowers may not be squeezed yet by the higher debt servicing costs.

When interest payments are typically being met through newly borrowed funds instead of income growth, EBITDA, or a similar earnings metric, this is a warning signal that the trend isn’t sustainable.

When the bubble goes into reverse, the same linkages on the way up – i.e., more borrowing leading to higher spending, leading to higher incomes, leading to more investment, which creates more valuable collateral and more borrowing, etc. – create the same downward spiral and become self-reinforcing.

Falling asset prices cause asset and collateral values to drop.

Since assets are typically bought on leverage, they often get squeezed out due to liquidity problems. Lenders pull back. Speculators need to sell, people have the increased need to raise cash to make debt payments and normal spending needs so assets are sold off, which drives prices down even further.

Lenders and investors also take their money out of risky assets and financial intermediaries that may have built-up leverage and bad debt problems from the run higher.

When these leveraging problems occur within key intermediaries or enough people are affected, this often becomes systemically threatening. In other words, they can threaten the viability of the entire economy.

How to Identify Bubbles