A question that has come up often in recent conversations is, are we in a bubble? It has often been said that asset bubbles can’t be identified except in hindsight. I don’t totally agree. I do know that bubbles can continue to inflate for months or years after they are first identified. I don’t think we’ll ever be able to fully explain why bubbles occur. It’s like asking why do you feel the way that you do—there are almost always several reasons, many of them conflicting. There are no simple answers here, but we will try and work through them and whether they apply to us today and what you should do about it in this week’s blog.
It seems to be every other week there is a hot market that people are investing/speculating in. Cryptocurrencies, Sports memorabilia including highlight videos on the blockchain, stocks pumped up by Reddit, Real estate raging like it’s the mid-2000’s and now SPACs are all the rage.
What are some of the reasons for these rapid increases in value?
Yes, there is a lot of new money in the system spurred by low-interest rates and continued Fed support.
There is also increased optimism in the vaccine roll out and we should not discount the fact that, while many are struggling financially, you have a high number of people at home with MORE disposable income and time on their hands.
But let take into account a reason bubbles happen that often goes overlooked and may apply to you personally: Investors often innocently take cues from other investors who are playing a different game than they are.
As Morgan Housel stated in The Psychology of Money
“Bubbles form when the momentum of short-term returns attracts enough money that the makeup of investors shifts from mostly long term to mostly short term. That process feeds on itself. As traders push up short-term returns, they attract even more traders. Before long—and it often doesn’t take long—the dominant market price-setters with the most authority are those with shorter time horizons. Bubbles aren’t so much about valuations rising. That’s just a symptom of something else: time horizons shrinking as more short-term traders enter the playing field.
The formation of bubbles isn’t so much about people irrationally participating in long-term investing. They’re about people somewhat rationally moving toward short-term trading to capture momentum that had been feeding on itself.”
So when will the bubble burst? That is a whole other can of worms and my answer is I don’t know. Nobody else knows either but saying “I don’t know” isn’t looked upon highly by the financial forecasting community.
I do know that bubbles can continue to inflate for months or years after they are first identified.
Perhaps the most classic example of an asset bubble continuing to inflate for years after it was first identified came in December 1996, when then chairman of the Fed Alan Greenspan spoke these famous words:
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
This quote was interpreted as a warning that Greenspan was worried that the stock market might be overvalued, and yet the market kept marching higher for the next four years. When this bubble finally burst in 2000, the NASDAQ fell 78% from peak to trough.
Although, when it did crash it didn’t stay below the December 1996 level, when Greenspan voiced concern, for very long. Chart here. If you did get out in December of 1996 you would have had to catch the market exactly at the bottom to have profited.
The people that were most hurt were those acting with too short of a time horizon. If they were acting as I wrote about HERE they got in too late and sold at the wrong time.
Also, there are always people who think we are in a bubble and around the corner from imminent doom as I wrote about before HERE.
It is reasonable to assume that our current bubble will continue to inflate, but it’s unknowable how far it may go. Speculation is rampant, margin borrowing is high, money is cheap (or free), Covid vaccines are rolling out, and more stimulus checks are on the way.
We asked at the top of this post if you should do anything about all of this information.
If you need the money in the next year or two then you should probably be in cash anyways.
If you aren’t invested and waiting for the right time let me share with you the story from my Friend and San Diego financial planner, Taylor Schulte
“My neighbor over the weekend said something to the effect of, “The market has to crash! I’m just waiting for it to crash so I can buy low.” And I’m like, dude, the market crashed less than 12 months ago! And it’s not uncommon for that to happen every few years.”
Let me also share with you this post from Nick Maggiulli who wondered Why is hoarding cash to “buy dips” such a seductive idea despite the overwhelming evidence against its success?
Bubble or not we should be invested in alignment with our investment time horizon and risk tolerance.
To tie this up in a nice bow…
Yes, we are probably in a bubble.
Nobody knows when it will pop or how bad it will be.
If you have a sufficient timeline you should probably stick to your plan and ride out the bumps.
If you have cash needs in the next 24 months you should probably keep it in savings unless you have a high-risk tolerance.
Market timing still doesn’t work.
Keep wearing your mask and stay safe.