Mirror, mirror, on the wall, which is the biggest asset bubble of them all?
An asset bubble is a fascinating constructs of human behaviour and economics. It is impossible to pick their peaks and they usually go on for much longer than most rational observers would deem possible. Most bubbles are rarely recognised for what they are, except in hindsight. When a bubble finally bursts in a sudden unexpected crash, their true nature suddenly becomes apparent to almost all.
The history of bubbles
Bubbles have been around for at least several hundred years and are a natural extension of modern economics. The first well-documented episode of a major economic bubble was the tulip bubble in the Netherlands which reached a peak in 1636 to 1637. The bubble, later nicknamed the Tulip Mania, involved rampant speculation in the prices of tulip bulbs. In early February 1637, the bubble collapsed almost overnight, as most speculators could no longer afford to buy even the cheapest bulbs. Later bubbles include various railway development bubbles such as in the U.S. and Britain and the famous British South Sea bubble involving stock price speculation. Closer to home, Australia has also had its fair share of bubbles and busts. One of the worst was the Melbourne Land Boom in the 1880s and 1890s. Melbourne land prices increased significantly as investors borrowed large amounts of money from banks to invest in land around Melbourne, having convinced themselves that prices would continue to rise for the foreseeable future. The bubble eventually burst in the early 1890s and led to an economic depression that took decades to recover from.
A common feature of bubbles is that investors are often pulled into the mania due to a combination of greed and a fear of missing out on big financial gains. Expectations of continuous price rises are often justified by relying on various unsupported beliefs. If confronted with scepticism from outside observers, speculators will usually assure themselves and others that “this time it is different” and that price rises this time around are justified. As is often the case: Everyone looks like a genius in a bull market. It’s often not until the end of a bull market that we can separate the sheep from the goats and determine who managed to win the latest “game of musical chairs”.
The worst bubble and subsequent bust in more recent history is undoubtedly the stock market bubble in the U.S. during the 1920s. The stock market speculation was unprecedented in the sense that people from all walks of life were speculating in the Dow Jones Industrial Average stock market, often with borrowed money. An American investor, Joe Kennedy, is often cited as coming to the realisation that the stock market had turned into a huge bubble when he received stock buying tips from a local shoe shine boy. Following its peak in October 1929, the value of the stock market dropped more than 80% (peak to trough) and it did not reach this level again in nominal terms until 1954 (25 years later). More recently, we have had the dot-com bubble of the late 1990s and the real-estate bubble in the U.S. and Europe. Yet very little has changed since those recent dramatic experiences. Investors and policymakers unfortunately tend to have a short-term memory.
The everything bubble?
Currently, the prices of pretty much every asset class have risen significantly in value since the last global downturn in 2008/2009. A major reason for this, is that prices are being inflated by ultra-easy monetary policies pursued by central banks around the world. This is a continuation of policies which were also responsible for the dot-com bubble and especially the real-estate bubble of the GFC. These policies have inflated the money supply around the world exponentially, including here in Australia:
Figure 1 – Australia Money Supply – M1
The problem with this rapid worldwide growth in money supply since the 1980s, is that has inflated asset prices around the world. This time around, the latest asset price inflation is taking place in multiple asset classes such as financial assets, real estate, high-end artwork and also in the latest tech innovation called cryptocurrencies such as Bitcoin and Ethereum. The breadth and extent of this current reinflation involving multiple assets classes is one reason it is starting to be labelled the everything bubble by some observers. The inflation of financial assets in many countries, especially in the U.S. has reached nosebleed territory, as clearly illustrated in the U.S. S&P 500 index below. How much longer can these financial asset price increases be sustained?
Figure 2 – S&P 500 Index historical chart
The tremendous rally in stock markets around the world is also partly due to an increasingly direct involvement of central banks in financial markets. The U.S. Federal Reserve (Fed), the Bank of England (BoE) and the European Central Bank (ECB) have bought a large amount of securities such as mortgage backed securities, government bonds and corporate bonds which are now kept on their balance sheets. Besides also investing in bonds, the Bank of Japan (BoJ) and the Swiss National Bank (SNB) have even gone as far as to buy stocks of private companies. The BoJ currently owns around 70% of all Japanese Exchange Traded Funds (ETFs) and the SNB is now a significant shareholder in companies such as Apple, Microsoft and Amazon. You may be wondering where the central banks are getting the currency from which they use to buy all these assets. Well, they simply create it out of thin air. Welcome to the magical world of modern central planning.
Figure 3 – Aggregate balance sheet of major central banks – US dollars
Source: Citi Research, Haver
With this increasing distortion of once free markets, many public companies are resorting to financial engineering rather than the usual standard business practices. Company executives have come to believe that they can make more money for their businesses by borrowing money and buying back their own shares rather than investing in productive capacity or R&D. In the short-term it seems to have worked out well, with asset prices being pushed up even further with these consistent share buybacks. The question though is where will the future growth and productivity increases come from if companies don’t make any real investments for the future? Without such investments, national economies will eventually suffer accordingly and it will get more difficult for these companies to service and repay this new debt.
Share buybacks is not the only driver affecting financial markets. Financial trading is increasingly being driven by algorithms rather than flesh and blood investors. These algorithms are programmed to trade the markets at near lightning speed and have almost made human trading obsolete. Financial trading is therefore increasingly becoming a game for the big players in town who can acquire the technical know-how to develop these programs and who have the funds to invest in the high-speed networks required for this high-frequency trading. These markets are therefore becoming less welcoming for whatever remains of the mom and pop investors out there.
Besides inflated financial asset prices, artificially low interest rates have also succeeded in reviving and enabling a slightly alternative re-run of the 2003-2007 U.S. and European property bubbles. Housing prices have increased significantly in cities such as San Francisco, Dallas, Stockholm and London. However, these re-inflated property bubbles in the U.S. and Europe are not alone. Real estate bubbles in Canada, China, New Zealand and here in Australia have also been feeding off easy global credit and low interest rates for many years without suffering any meaningful corrections so far. The average price for a detached house in Greater Vancouver in Canada is currently (as of June 2017) around CAD 1.8 mn (approx. AUD 1.8 mn) having risen more than 450% since the year 2000. In Australia, median house prices have increased almost five-fold since the mid-1990s.
Extremely low interest rates, which according to some estimates are the lowest in 5,000 years of recorded history, have also had a direct impact on bond prices.
Figure 4 – Global interest rate history
Source: BofA, Bank of England, Homer & Sylla”A History of Interest Rates” (2005)
Bond yields of many countries’ sovereign debt are now the lowest in hundreds of years. There is a frantic demand for bonds of every kind with little concern for potential risks such as defaults or a rise in rates. One of the most blatant examples of the extreme distortion of the world’s bond markets is the recent issuance of a 100-year Argentinian government bond. These bonds were so sought after by investors that the issuance was oversubscribed 3.5 times. Such a high demand for these bonds is bizarre considering the fact that Argentina has defaulted on its debts five times in the last century, most recently in 2014 (a little more than 3 years ago). Argentina thereby joins other “high-risk” nations such as the Ivory Coast where the recent sale of national debt was oversubscribed. Oversubscription for sovereign bonds is especially widespread in developed regions such as Europe and Japan which are commonly regarded as “less” risky. Here strong demand for bonds have pushed yields of a large portion of the sovereign debt into negative territory. In fact, around 15% of the total global sovereign debt market currently has a negative yield. In other words, the buyers of those bonds are actually paying these governments to borrow money. If such circumstances do not cause current investors to question the long-term sustainability of these markets then nothing will.
Although the global sovereign debt market is the prime candidate for the most inflated bubble here and now, and probably of all time, there are several other smaller bubbles out there which are not widely reported. In the U.S., the epicentre of most of the great asset bubbles of the 20th and 21st centuries, enormous investments have been pouring into the auto sector, education sector and the shale oil & gas industry. Since 2003, the amount of outstanding student loans in the U.S. has increased by almost 1.2 trillion U.S. dollars (a quintupling in less than 15 years) and outstanding auto loans have doubled. Meanwhile, investors are falling over themselves to invest in the American shale oil sector even though almost of the oil companies operating in that sector are not making any profits. As is customary in bubble behaviour, shale oil is accompanied with plenty of fanfare, with politicians and many media outlets proclaiming it to be an energy revolution and that the U.S. could even become energy independent.
The party must eventually come to an end
So, how do you know if a particular asset class may have turned into a bubble? Well, if you hear anyone uttering the words “it’s different this time” to explain rising prices in that particular asset class, you might want to tread carefully.
Will this everything bubble turn out to be the grand finale of asset bubbles for the foreseeable future, or will the central planners once again succeed in squeezing out a new round of asset bubbles from whatever remains of their monetary stimulus tools. Only time will show. This everything bubble would though be a worthy way to end one of the most concentrated periods of economic bubbles in all of history. It would be a real bang of a celebration as this time we have managed to inflate bubbles in almost every asset class imaginable. However, as with all parties they eventually come to an end. Hopefully some of the many investors out there have remembered to stock up on plenty of painkillers, because the hangovers after this latest party may turn out to be much worse than the previous bubble parties.