The Bubble That Could Break the World

The Bubble That Could Break the World

The key to bubble analysis is to look at what’s causing the bubble. If you get the hidden dynamics right, your ability to collect huge profits or avoid losses is greatly improved.

Based on data going back to the 1929 crash, this current bubble looks like a particular kind that can produce large, sudden losses for investors.

As the past week has dramatically proved, the market has been especially susceptible to a sharp correction.

Now, I’m not saying this is the bubble finally bursting — it is still only a pullback right now — but it is a major warning sign that bubble dynamics are in effect.

Before diving into the best way to play the current bubble dynamics to your advantage, let’s look at the evidence for whether a bubble exists in the first place…

This measure is at the same level as 1929

My preferred metric is the Shiller Cyclically Adjusted P/E Ratio, or CAPE. This particular P/E ratio was invented by Nobel Prize-winning economist Robert Shiller of Yale University.

CAPE has several design features that set it apart from the P/E ratios touted on Wall Street.

The first is that it uses a rolling 10-year earnings period. This smooths out fluctuations based on temporary psychological, geopolitical and commodity-linked factors, which should not bear on fundamental valuation.

The second feature is that it is backward-looking only. This eliminates the rosy scenario of forward-looking earnings projections favoured by Wall Street.

The third feature is that that relevant data is available back to 1870, which allows for robust historical comparisons.

The CAPE today is at the same level as in 1929, just before the crash that started the Great Depression. The second is that the CAPE is higher today than it was just before the panic of 2008.

Neither data point is definitive proof of a bubble. CAPE was much higher in 2000 when the dotcom bubble burst. Neither data point means that what we’re seeing now is the bubble finally bursting.

But today’s CAPE ratio is about 185% of the median ratio of the past 137 years.

Given the mean-reverting nature of stock prices, the ratio is sending up storm warnings, even if we cannot be sure of exactly where and when the final hurricane will come ashore.

With the evidence of a bubble clear, we can now turn to bubble dynamics. The analysis begins with the fact that there are two distinct types of bubbles.

Two things drive all bubbles

Some bubbles are driven by narrative, and others by cheap credit. Narrative bubbles and credit bubbles burst for different reasons at different times.

The difference is critical in knowing what to look for when you time bubbles, and for understanding who gets hurt when they burst.

A narrative-driven bubble is based on a story, or new paradigm, that justifies abandoning traditional valuation metrics.

The most famous case of a narrative bubble is the ‘Nifty Fifty’ of the late 1960s and early 1970s. This was a list of 50 stocks that were considered high growth, with nowhere to go but up.

The Nifty Fifty were often referred to as ‘one decision’ stocks because you would just buy them and never sell. No further thought was required.

Of course, the Nifty Fifty crashed with the overall market in 1974 and remained in an eight-year bear market until a new bull market began in 1982.

The dotcom bubble of the late 1990s is another famous example of a narrative bubble. Investors bid up stock prices without regard to earnings, P/E ratios, profits, discounted cash flow or healthy balance sheets.

All that mattered were ‘eyeballs’, ‘clicks’, and other superficial internet metrics. The dotcom bubble crashed and burned in 2000.

The NASDAQ fell from over 5,000 points to around 2,000, and then took 16 years to regain that lost ground before recently making new highs.

Of course, many dotcom companies did not recover their bubble valuations because they went bankrupt, never to be heard from again.

The credit-driven bubble has a different dynamic than a narrative-driven bubble.

If professional investors and brokers can borrow money at 3%, invest in stocks earning 5%, and leverage 3-to-1, they can earn 6% returns on equity plus healthy capital gains, which can boost the total return to 10% or higher. Even greater returns are possible using off-balance sheet derivatives.

Credit bubbles don’t need a narrative or a good story. They just need easy money.

A narrative bubble bursts when the story changes. It’s exactly like The Emperor’s New Clothes, where loyal subjects go along with the pretence that the emperor is finely dressed until a little boy shouts out that the emperor is actually naked.

Psychology and behaviour change in an instant.

In 2000, when investors realised that was not the next Amazon but just a sock-puppet mascot with negative cash flow, the stock crashed 98% in nine months — from IPO to bankruptcy. The sock puppet had no clothes.

A credit bubble bursts when the credit dries up. The Fed won’t raise interest rates just to pop a bubble — it would rather clean up the mess afterwards than try to guess when a bubble exists in the first place.

But the Fed will raise rates for other reasons, including the illusory Phillips Curve, which assumes a trade-off between low unemployment and high inflation, currency wars, or to move away from the zero bound before the next recession. It doesn’t matter.

Higher rates are a case of ‘taking away the punch bowl’, and can cause a credit bubble to burst.

The other leading cause of bursting credit bubbles is rising credit losses. Higher credit losses can emerge in junk bonds (1989), emerging markets (1998), or commercial real estate (2008).

Credit crack-ups in one sector lead to tightening credit conditions in all sectors, and lead in turn to recessions and stock market corrections.

What type of bubble are we in now?

My starting hypothesis is that we are in a credit bubble, not a narrative bubble.

There is no dominant story similar to the Nifty Fifty or dotcom days. Investors do look at traditional valuation metrics rather than invented substitutes contained in corporate press releases and Wall Street research.

But even traditional valuation metrics can turn on a dime when the credit tap is turned off.

Milton Friedman famously said the monetary policy acts with a lag. The Fed has force-fed the economy easy money, with zero rates from 2008 to 2015 and abnormally low rates ever since. Now the effects have emerged.

On top of zero or low rates, the Fed printed almost $4 trillion of new money under its QE programs. Inflation has not appeared in consumer prices, but it has appeared in asset prices. Stocks, bonds, commodities and real estate are all levitating above an ocean of margin loans, student loans, auto loans, credit cards, mortgages, and their derivatives.

Now the Fed is throwing the gears into reverse. It is taking away the punch bowl.

The Fed has raised rates five times since the end of 2015, and is on track to raise them again this year under new Chairman Jerome Powell.

In addition, the Fed has begun to throw QE into reverse by reducing its balance sheet and contracting the base money supply. This is called quantitative tightening or QT, which I’ve discussed repeatedly.

Credit conditions have already started to affect the real economy. Student loan losses have been skyrocketing, which stands in the way of household formation and geographic mobility for recent graduates.

Losses have also shown up in subprime auto loans, which has put a lid on new car sales. As these losses ripple through the economy, mortgages and credit cards will feel the pinch.

A recession will likely follow.

What we are seeing now in the stock market is a tremor. It will ultimately crash in the face of rising credit losses and tightening credit conditions.

No one knows exactly when the bubble will burst for good, but we’ve just gotten a small taste of what it will be like. Once it happens, it’ll be too late to act.

Do you have your gold yet?


Jim Rickards Signature

Jim Rickards
For The Daily Reckoning Australia