What All Bubbles Have In Common

My Comments: My brain is tired. Too much political angst, too much monetary crap, not enough positive feedback. And here’s some more monetary crap.

But if you are like me and are not expecting to win the lottery anytime soon, then bubbles become important. And like it or not, they tend to burst and create chaos. Look at this chart and read the article to determine where we are right now. Maybe.

bubbles

Sep. 16, 2016

Summary

  • By far, the main cause of bubbles is excessive monetary liquidity in the financial system.
  • Investors are showing signs of behavior consistent with asset bubbles such as herding, hindsight bias, confirmation bias, anchoring, overconfidence and greater fool.
  • We’re at the final stages of the bubble and the rise in the LIBOR and government bond yields are the first warning signs.

What causes a bubble?

By far, the main cause of bubbles is excessive monetary liquidity in the financial system. Axel Weber, former Deutsche Budesbank President puts it this way: “the past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset price bubbles.” This makes you think about today’s Central Banks’ ultra-loose monetary policy for several years, right?

In fact, when too much liquidity is given to normal citizens, it usually ends up in inflation whereas when that additional liquidity finds its way to the hands of the wealthiest, it usually ends up in bubbles. That is because poor people have a higher propensity to consume than rich people who have a higher propensity to save.

So, an extra buck on a poor guy’s wallet will probably end up in consumption while an extra buck on a rich guy’s bank account will more likely end up in savings. This supports the claim that Central Bank’s monetary policy is not reaching the real economy and is only making the rich (who own assets) even richer.

What about investor’s psychology?

Bubbles also have an emotional component. As Dan Ariely said “humans may be irrational, but they are predictably irrational.” Here are a few common behaviors that lead to the creation of bubbles.

Humans are biologically wired to mimic the actions of the group. While this behavior allows us to quickly absorb and react based on the intelligence of others around us, it also leads to self reinforcing cycles of aggregate behavior. This is called herding and it explains popular investment strategies such as momentum or trend following.

Investors also overestimate their ability to predict the future based on the recent past. This tendency to overemphasize recent performance is called hindsight bias and just like herding is one of the reasons behind the success of momentum and trend following investment strategies.

Both herding and hindsight bias, explain why a growing number of investors use technical analysis alone to make their investment decisions and fewer investors care about fundamental analysis and about the price they pay for a certain asset. This is why, when faced with the warning that valuations are currently at very high levels, many investors say this is not “actionable.” For them, what is “actionable” is 2 moving averages crossing on a chart.

People also tend to seek information that supports their own theories, and usually ignore information that disproves their points of view. This is called confirmation bias and can be found in today’s failed attempts to justify expensive valuations with the fact that stocks earnings yield and dividend yield is higher than government bond yields.

Anchoring consists in investors’ need to have references. So, if a stock trades today at $100, investors will perceive $90 as cheap and $110 as expensive.

People also tend to overestimate their intelligence and capabilities relative to others. For example, a 2006 study showed that 74% of professional fund managers believe they delivered above average performance. This overconfidence grows as the asset prices increase and is usually at its high before the crash. It is just like the story of the turkey whose trust in the farmer grows by the day because the farmer feeds him every day. And when the turkey’s trust in the farmer is greater than ever, that’s when the turkey loses his head.

This year has been all about buying the dips because anytime there were bad news on China (in January), on the US (May jobs report), on Europe (Brexit vote in June) or on disappointing earnings (it has now been 5 consecutive quarters of earnings decline), everyone followed the same reasoning: The ECB will ease further, the BOJ will add stimulus, the Fed won’t hike and/or the BOE will cut interest rates.

But the current selloff is about the Fed raising rates and the BOJ and ECB reducing monetary stimulus. Will anchoring and overconfidence make investors buy this dip?

Finally, there’s the greater fool theory that says rational people will buy into valuations that they don’t necessarily believe, as long as they think there is someone else more foolish who will buy it for an even higher value. Do negative yielding bonds ring a bell here?

In which phase of the bubble are we?

Jean-Paul Rodrigue says every bubble goes through 4 stages: stealth, awareness, mania and blow-off.

The way I see it, the S&P 500  took-off in 2009, went through a bear trap in 2012 and is now somewhere between Delusion and the New Paradigm, if not already at the beginning of the denial.

In Summary

There’s evidence of exceptional amounts of liquidity in the financial system today as investors are showing the behavior we see in the final stages of a bubble.

In fact, there are reasons to believe that Central Bank policy is changing and when that happens, the Bubble will pop. On the one hand, the libor rose to 83 basis points over the summer, the highest since 2009 and surpassing the levels seen at the peak of the European sovereign debt crisis and it seems to have already incorporated a potential 25 basis point rate increase by the Fed. On the other hand, Government bond yields in Germany, Japan and the US have been rising over the summer specially in the longer part of the curve.

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