Reviewed February 2021

BUBBLE TROUBLE

Abstract:  Wall Street, Washington and the financial press consistently frame financial markets in an optimistic manner and encourage investing in equities and other asset classes.  When equity prices rise relentlessly, as has been largely the case for 2009 through 2021, investors begin to believe that prices always rise and don't want to miss out.  When prices hit record highs constantly, as was the case in 2020 and early 2021, investors chase prices and ignore the value they receive for price paid.  Value received is the primary determinant and best predictor of forward 10-year returns.  The Shiller CAPE and Buffet indicator are two well-respected value indicators.  Value received per dollar invested in US equities is the worst it's ever been by well-respected measures of value in early 2021.

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ANALYSES OF ASSET BUBBLES AND BUSTS

A bubble then bust pattern has been observed, described and analyzed for three centuries or so and applies to virtually all asset markets, not just equity markets.  It seems to be something inherent in human nature which intermittently creates speculative bubbles.  Definitions of bubbles from various sources are quite similar and Investopedia's would be typical.  Investopedia defines a bubble as "an economic cycle characterized by rapid escalation of asset prices followed by a contraction.  It is created by a surge in asset prices unwarranted by the fundamentals underlying the asset and driven by optimistic and exuberant market behavior.  When no more investors are willing to buy at the elevated price, a massive sell-off occurs, causing the bubble to deflate."  The causes of bubbles and busts thus are embedded in human nature and herd emotions, not reason or fundamentals.

A market, formal or informal, exists in everything.  Assets in bubbly markets become expensive relative to value received.  At some point which cannot be identified or timed in advance prices stop rising, the bubble pops and a rapid decline in prices results.  Prices stop declining when they are well below what macroeconomic data and fundamentals would justify or support and a bear market ensues.  Economic troubles can persist for decades.  After prices decline assets offer a very good value for price paid but unfortunately after a fall in prices has occurred most investors are reluctant to enter markets.

The first reasonably detailed analysis of the psychology of bubbly asset markets should probably be credited to Charles Mackay, "Extraordinary Popular Delusions and the Madness of Crowds", published in 1841. Mackay's book presents an analysis of bubbles from the early 1600's through the early 1800's and includes The Mississippi Scheme, the South Sea Bubble, the Tulip Mania, The Crusades, the Witch Mania, The Slow Poisoners and other follies and bubbles of that era.  The emotional, mental, social and economic dynamics underlying them are very similar as are those found in asset bubbles in the US in the late 20th century.  Human nature hasn't changed.  Bubbles are just something that humans occasionally create.

Below are brief summaries of three books which provide asset bubble analyses and models from contemporary authors.  As good a guess or explanation of market pricing as any is that asset prices are about half driven by the herd emotions of greed and fear and half driven by macroeconomic and fundamental facts and events in the real world.  Their respective contributions can't be measured or compared quantitatively.  One clear conclusion to be taken from these books is that lasting national wealth and prosperity cannot be created much if at all from printed or digital money creation by central banks, long-term jumps in national debt, ultra-low interest rates or government legal dictates.  It takes effort, time, investment, creativity and luck to create national wealth.

CHARLES KINDLEBERGER, "MANIAS, PANICS AND CRASHES", 1996.

Perhaps the best academic analysis of bubbles available is still the aptly titled "Manias, Panics and Crashes" by Charles Kindleberger, Ph.D.  Wiley, 1996.  Dr. Kindleberger was a professor of economics at M.I.T. for 33 years and published 24 books.  In "Manias, Panics and Crashes" he analyzes bubbles and crashes in numerous asset classes from 1600 through 1990 including coins, tulips, canals, bonds, stocks, real estate, agricultural land, gold, and various minerals.  He finds bubbles grow from several factors but common drivers are a rapid expansion of the money supply, low interest rates, high leverage and unbridled optimism.  Central banks originally arose to impose control on the instability of credit markets but have never really been all that successful at controlling credit and market prices or economies when big economic or market problems arrive.  Even with money creation tied substantially to the price of gold in the U.S. prior to 1971, bubbles, bear markets, recessions and depressions occurred.

Kindleberger's analysis largely emphasizes the emotional and irrational in market prices as opposed to what's sometimes called the strong or rational form of efficient market theory.  It proposes markets are efficient and rationally price assets at all times even if they can't be understood or timed.  Kindleberger notes that a financial crisis is "associated with changed expectations that lead owners of wealth to try to shift quickly out of one type of asset into another, with resulting falls in prices….and frequently bankruptcy."  Markets have repeatedly shown they can be irrational and inefficient in pricing assets short-term but because timing and predicting when price changes will occur is impossible it really may not make much difference to investment returns whether investors believe in irrationality and inefficiency or not.  Prices are unpredictable.

EDWARD CHANCELLOR, "DEVIL TAKE THE HINDMOST:  A HISTORY OF FINANCIAL SPECULATION", 1996.

In "Devil Take the Hindmost: A History of Financial Speculation", Edward Chancellor, 1999, provides a narrative history of bubbles and crashes.  Chancellor studied history at Cambridge and Oxford and worked for Lazard Brothers, an investment bank, in the 1990's, later joining Grantham's GMO investment firm in 2008.  He examines speculation in many of the same financial events over the last 300 years as Kindleberger including the South Sea Bubble, the Railway Mania of 1845, the Crash of 1929 and the Japanese Bubble economy of the 1980's.

Chancellor argues that the psychology of market speculation is "almost indistinguishable" from gambling and that speculation in markets is addictive and often leads to delusional behavior.  In the alternative world of highly efficient markets where there are no animal spirits there can be no "irrational "speculative bubbles.  Chancellor suggests that when a bubble is underway "the Dionysiac aspect of the carnival survives in the conspicuous consumption and revelry of speculators" and a "festive perception of the world."  When the bubble pops speculative feelings are quickly forgotten and quickly disappear.  He states "The essence of speculation remains a Utopian yearning for freedom" which "counterbalances the drab rationalistic materialism" with "its inevitable inequalities of wealth".  Markets often follow price trends as is the case in early 2021 as high frequency trading computers apply formulas in an attempt to beat the market.  He also repeats Keynes's wise warning from the 1930's: "when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done."

Chancellor examines recurring crash themes where events suddenly change market expectations and investors realize that a government's currency policies are inflationary or destructive, and an asset price bubble reverses.  A herd mentality may develop where investors respond to rumors and fears of insolvency or a confluence of several negative factors rather than just one defining cause.  A typical central bank reaction to large asset price declines is to become the "lender of last resort" and provide unlimited amounts of fiat currency at very low interest rates.  This has been the case in the United States between 2008 and 2021.  Such a maneuver averts disaster short-term but results in constant currency debasement and inflation, burdens nations with debt service and drives economic underperformance long-term.  On March 3, 2020 the Fed dropped the critical overnight money rate by 0.5% to around 1.5% even though rates before the announced drop were about one-third average and all maturities of all Treasury offerings were below the rate of inflation which is about 2%.  This is unprecedented, indicates major economic weakness, and did not fit the Fed's narrative that the US economy was doing well.  A normal average overnight money rate would be in the 5% to 6% range.

Future tax revenues are almost always promised as a way to pay off borrowed money but somehow these payoffs rarely happen.  For example, from 2009 to 2021 the US deficit grew from about $10 trillion to about $27 trillion.  This occurred despite repeated government assurances during the last decade that the US would pay down its national debt.  Worse still, much of the borrowed money, debt, flows through to GDP output statistics when it is spent into the economy and adds to GDP making it look larger than it really is.  However, borrowing money from the future, spending it now, and declaring the borrowed money to be current GDP growth isn't really much more than an accounting ritual.

"THE HISTORY OF FINANCIAL DISASTERS", MULTIPLE EDITORS, 3 VOLUMES, 2006.

"The History of Financial Disasters" provides very detailed scholarly descriptions of past bubbles and crashes.  It covers 19 financial crises including most of those examined by Kindleberger and Chancellor, and the articles were written by eminent experts in the crises covered. Not surprisingly, the same themes show up in this three volume analysis as in Kindleberger's and Chancellor's books.  Crises are often triggered by currency debasement and inflation, excessive leverage, the sudden collapse of large borrowers, the suspension of a gold standard which pegs money supply growth to something of value in the real world (gold), a sudden collapse of confidence not closely tied to external events at all, shifts in international capital flows, or the exhaustion of the total pool of bullish potential investors and their money. Often a financial disaster is triggered through the confluence of several factors, not one defining cause.  Overall, financial crises are the product of sudden alternations of expectations that may or may not be rooted in reality.  And, bubbles and crashes are almost always surrounded by broader narratives such as changing conceptions of government and central bank intervention in markets, promotional industry narratives, and the globalization of markets.  Almost anything can collapse a speculative bubble since feelings play such a prominent role in bubbles and crashes and they can change very fast and are not necessarily tied to facts.  Ultimately, bubbles and crashes are simply the result of human emotions and human nature.

THE PSYCHODYNAMICS OF BUBBLES AND CRASHES

What is probably most surprising about asset bubbles is that well-established well-known frameworks for identifying bubbles exist.  Unfortunately, these are almost always ignored when prices are rising fast.  Making money without working is so much fun.  Also surprising is the agreement of the three authors above on what causes bubbles and crashes.  There is little doubt.  Bubble psychodynamics appear to be reasonably well defined and consistent.  Getting rich quick has a very strong appeal and the presence of a bubble is usually discussed in retrospect if at all.  Although the elements driving a bubble are identifiable in advance and some metrics that define a bubble can even can be quantified as Hegel said "We learn from history that we do not learn from history".  Little effort is made to discuss bubbles as long as prices are high and rising.  At the top of bubbles investor enthusiasm and market prices are far too high and almost everyone who has the wherewithal is in the markets.  The opposite prevails only after markets have crashed.  First prices change, then narratives change.  After the crash overoptimistic narratives that fed the bubble usually disappear for a while only to reappear in the next bullish cycle.  Investors never seem to learn.

One week before the Dow entered a 25-year bear market in late 1929 Irving Fisher, the nation's most eminent well-known economist, was on the cover of Time magazine proclaiming that US stocks markets had reached "a permanently high plateau".  In an echo of 1929 on 2-17-2020 the WSJ published an article entiteled "How High Should Government Debt Go?  Economists Can't Agree".  According to the WSJ some economists now feel that high debt levels may not be economically risky.  History begs to differ and offers numerous examples of debt based financial crises but the optimists always argue that "this time is different".

A prime example of our current extra-exuberant equity bubble circa early 2021 is Tesla.  Its price rose a spectacular 800% from April 2020 into February 2021.  Its stock market value exceeded that of the other major auto makers combined.  Yet, the only part of Tesla's business model that could possibly be called a profit, courtesy of government regulations, is the sale of greenhouse gas credits to other OEM manufacturers and tax subsidies, neither of which is sustainable nor based on TSLA's automotive business.  Tesla has never made a profit selling automobiles.  Net of selling credits Tesla loses money and the buyers of these credits, GM, Audi, Fiat-Chrysler etc., will soon be selling more than enough electric vehicles and hybrids to remain in compliance with new vehicle regulations and not need to purchase any more electric vehicle credits from Tesla.

Joining Tesla in early 2020 were other very popular mega-cap "growth" stocks of the current era with spectacular annual stock price gains in 2019: AMZN, up 33%, AAPL, up 91%, GOOGL, up 36%, and MSFT up 71%.  These stocks continued upwards to repeated new highs during 2020.  Very large percentage stock price gains in one year are abnormal,and difficult to understand in terms of any fundamentals given the highly competitive businesses these companies are in and a subpar 2019 and 2020 US GDP growth rate about 1% below average.  Dimson et. al. ("Triumph of the Optimists", 2001) estimates an inflation adjusted average long-term dividend income growth rate, the only income stocks provide, of 0.58% annualized.  The rest of long-term equity returns, about 4.5% annually, is in the prices and they can go anywhere.

As is well illustrated in the three books above, the economic theory one uses to interpret the causes of economic and market problems and how to remedy them are linked and debatable.  Keynesians support high money unit creation and economic stimulus by governments and central banks along with low interest rates to support economies.  Free market economists frown upon central bank and government engineered interventions and argue that their effects are brief and ineffectual.  They advocate minimum intervention and letting free markets determine the price of money, the quantity and quality of debt and how fast an economy grows.  Financial history clearly shows that lasting growth and national wealth cannot be created much if at all from printed or digital money created by central banks and government borrowing from the future.It can do wonders for economic statistics short term.

Attempts to boost economic output through excessive money supply creation, very low interest rates, and loosened capital regulations are continuously promoted and almost always enacted by central banks and governments in economic downturns.  Everyone likes economic growth.  Prices rise if money supply creation is faster than economic growth.  Once the US went off any link between gold and the US dollar money supply in 1971, first slowly and now rapidly as of 2021, money supply expansion became multiples of US GDP growth and both the CPI cost of living and, even more rapidly, the cost of assets termed "investments" rose.

Continuously rising prices make investors continuously happy and investors talk about "appreciation" as if prices can't and won't decline.  For example, the popular Nasdaq 100 stock index rose about 420% from 2009 through 2019 while US GDP, inflation adjusted, only grew a little over 22%.  How is this possible?  Obviously, stock prices should be somewhat tied to GDP growth and probably not grow at 19 times GDP growth.  Will the index eventually decline to a more reasonable valuation?  That's highly likely.  And, bubbly stock prices with record or near record overvaluation metrics as of early 2021 do not make any sense in terms of over a century of valuation data and prices.  Should we ignore this data and assume "this time is different"?

One popular theory of why bubbles burst is the idea that the last "greater fool" has put their money in the market, no more money is available for the market, and the market stops rising and is considered "exhausted".  It then suddenly reverses for no particular reason on no particular day.  Greed then quickly turns to fear as prices drop and a selling panic starts.  As I watched US equity markets decline rapidly in March 2000 few narratives explained why huge percentage drops in equity prices were occurring other than vague claims that maybe markets were maybe ahead of themselves and "overexuberant" and needed a "breather".  After the initial price decline in early 2000 Wall Street, as it always does, proclaimed the decline a buying opportunity.  Investors then lost another 10% to 50% on that advice depending on their equity allocation.  During bubbles investors primarily react to changes in share prices, buying what goes up and selling what goes down.  This has come to be known as momentum investing or price momentum investing.  It was widely popularized by William O'Neill of "Investors Business Daily" in the 1980's and 1990's.  As of 2021 price momentum trading is done by high frequency trading computers that place buy and sell trades in a billionth of a second without human intervention.

ARE MARKETS AS OF EARLY 2021 IN A BUBBLE?

We cannot know the answer to this question with certainty but several valuation and economic metrics clearly show a major equity bubble is in place.  Equity valuation metrics and economic fundamentals have been largely ignored as high frequency trading computers dominate market prices and play with numbers.  Yet, as of Winter 2020 market data show record and near record overvaluation in US equity markets as measured by the best predictive valuation metrics that explain the majority of forward 10-year returns.  That includes the Shiller CAPE and Buffet Indicator, both indicating US equity markets are 2x average valuations as of early 2020, are at or near record price levels, and are 3x bargain valuation levels.  Both measures are well-respected and predict forward 10 year returns with a 0.85-0.9 correlation, very strong.  As of 2-15-20 the Shiller CAPE p/e, was 33.3:1, twice the long-term average mean of 16.7:1 and close to an all-time record for overvaluation.  US equity markets are still very expensive and as of early 2021 carry a Shiller CAPE around 35:1.  Either all past financial data don't tell us anything at all or there's trouble ahead for markets.

What historically has come after periods of high and rising valuations and a long bull market has been a major price reversal and a bear market.  US GDP growth has been subpar by about 1% annually over the last decade yet US equity markets consistently hit new highs in throughout 2020 based on strong optimism about a period of big equity price gains dead ahead along with very low interest rates and large continuing increases in US money supply.  That optimism follows the spectacular much above average equity returns of the prior 10 years up to 2020 and the longest bull market since WWII.  Record stock prices with record overvaluation metrics do not augur well for future returns.  We shall see where record overvaluations and continuous optimism take us in the future.

REFERENCES:

Altorfer, S. et al.  "History of Financial Disasters, 1763-1995".  Three volumes, 2006.

Chancellor, E.  "Devil Take the Hindmost", 1999.

Kindleberger, C. "Manias, Panics and Crashes", 1996.

Mackay, C.  "Extraordinary Popular Delusions and the Madness of Crowds", 1841.