Friday, August 1, 2014

Bubbles, bubbles everywhere?

To hear some analysts talk, you’d think the entire financial market was just one gigantic bubble waiting to implode.  Even mainstream media outlets are on full bubble alert with mention of the word “bubble” being mentioned in news headlines on almost a daily basis.  Here’s a collection of recent headlines from blog postings and news sites:

“Bubbles, Bubbles Everywhere”
“The Implosion is Near: Signs of the Bubble’s Last Days”
“When Bubbles Become Manias: The Psychology of Runaway Markets”
“Are Speculative Bubbles Good?”
“Janet Yellen and Bubbles”

Analyst and financial commentator Sy Harding made a good point in a recent edition of his newsletter.  He points out that the U.S. experienced two unusual bubbles in the first eight years of the new century, viz. the Internet stock bubble in 2000 and the housing bubble in 2006.  As Harding points out, before 1999/2000, most investors were probably unfamiliar with the concepts of a financial market bubble.  Yet now, after two back-to-back implosions, everyone sees bubbles even when they don’t exist.  Clearly the historic events of the last 14 years have left a deep scar on investors’ collective psyche – a scar that has yet to heal. 

As Harding mentions in his newsletter, investors frequently use the concept of a bubble as a risk assessment tool.  The “logic” behind this thinking goes something like this:  “If we can determine the market is in a bubble we can get out because it’s due for a serious collapse, but if we can determine it’s not in a bubble we can be assured the bull market has several more years to go.”  Harding rightly points out the fallacy of this thinking, not to mention the potential pitfalls it involves.

Harding writes that there have been 25 bear markets in the last 113 years for an average of one every 4.5 years.  The average decline of these bear markets was 36.5% with the ten worst ones averaging a decline of nearly 50%.  “How many of those serious bear markets were the result of the market being in a valuation bubble that burst?” he asks rhetorically.  Answer: 1929 and 2000.

“Bear markets begin,” writes Harding, “as did the 2007-2009 bear, not due to bubble-level valuations being reached and then bursting, but in anticipation of a slowing economy and potential recession or financial crisis (domestic or global), rising inflation, rising interest rates, global events, or just because the bull runs out of energy.  At those times, stocks are usually overvalued, but not to anywhere near bubble proportions.”

As Harding points out, the market has achieved bubble conditions an average of perhaps once or twice in a lifetime.  By contrast, stock market corrections of 10% to 20% an average of once a year, and a serious bear market occurs an average of once every 4.5 years.  As Harding concludes from this study, it’s time to “cool down the bubble talk” as whether or not we’re in a bubble has little bearing on the level of market risk or whether or not a bear market will occur.