Max Pacella
Investment Analyst
Macro & Markets
9 Jul, 2021

“Is this the next housing bubble?”, “Is Bitcoin a bubble?”, “Irrational exuberance”.

Each time a particular asset’s price grows to potentially sensational valuations, you begin to hear phrases like the above.

Particularly since the Global Financial Crisis of 2007-2008, bubbles have formed part of the market’s collective psyche, seen as buying opportunities by some and symptoms of a deathly ill market by others.

Whichever side you take, asset bubbles or speculative bubbles do exist and can be catastrophic tail-risk events for markets in both directions for the unprepared investor.

Bubbles tend to operate in cycles which can sometimes be identified by the economics of the market, or by the psychology of its participants.

We will explore a few definitions and measurements of bubbles in this note.

 Broadly, however, there are two baseline assumptions which we will establish at the start:

1) The general identity of a bubble is a rapid inflation in the value of an asset, generally creating a self-perpetuating cycle where the increasing price encourages more investment, driving the price higher until finally profit-taking ensues and the price has an equally aggressive collapse.
2) It is generally agreed that bubbles are identified only after the bubble itself has burst and we are in the “despair” phase of the cycle.

The Five Stages

A note about bubbles would be incomplete without mentioning Hyman Minsky, an American economist who studied financial instability and the stages of a credit cycle in the 1980s.

Part of his study touched on speculative asset bubbles which were endogenous (correlated to other factors within the system) to financial markets.

Minsky identified key stages in his studies which have since been related to other asset markets beyond credit cycles. These are:

  1. Displacement
    Initial investors begin to notice a new asset or ‘paradigm’, for example discovering a new technology or a unique economic circumstance. The “initial attention” phase.
  2. Boom
    The price of the asset starts to see a build-up of momentum from the initial attention, with new investors beginning to participate in the market on the back of speculation in the rising prices. The “FOMO” phase.
  3. Euphoria
    The price of the asset sees the most aggressive period of inflation, generally garnering wider attention from the media and less sophisticated investors. This is often the stage where you may see multitudes of new “investment strategies” forming around the one asset class, excitement going beyond markets into conventions or ‘hype events’. The “To the Moon” phase.
  4. Profit Taking
    A few key holders begin to start selling off to lock in gains, generally those who got in at early stage 1 or 2. The “Risk Management” phase.
  5. Panic
    Almost the inverse of stage 2, once the price starts to drop investors begin to liquidate positions rapidly, which drops the price further and incites further panic selling. Market psychology entirely shifts, and the asset is in free-fall with “a wall of selling”. The “Going to Zero” phase.

It’s generally easy to call phase 5, but only a select few in any bubble can accurately predict phase 4 – in fact it’s likely a combination of luck and autocorrelation, those who call phase 4 and sell may end up being the ones who kick phase 4 off in the first place.

Cyclically Adjusted Price Earnings (CAPE) Ratio

Most of the time what we perceive as bubbles are just market dislocations – asset prices stray from their intrinsic values all the time without necessarily crashing back down afterwards.

One method which is employed to assess if something is a bubble, is to test how relatively expensive an asset is from its fundamentals – we will use equity markets as an easy example for this.

A popular test for this is known as the CAPE Ratio (or sometimes the Shiller Ratio), a ratio which takes a listed company’s stock price and divides it by the ten year average of that company’s earnings (adjusted for inflation).

We take ten years and adjust for inflation because this is a more accurate assessment of long-term financial performance excluding the impact of economic cycles – a company’s earnings may be highly elevated in a booming economic market, or may be severely depressed in a recession, but that does not mean on a long term basis that the stock is ‘cheap’ or ‘expensive’.

Historically, a high CAPE ratio implies a stock price is substantially overvalued, which also translates to markets in general. Below shows the current CAPE ratio for the S&P 500 (which has an average ratio of 16.84) is currently 38.26; the second highest after the Dot-Com bubble.

Source: multpl

So, you may potentially look at this index and think that stocks within the S&P 500 are overvalued at these levels, as you may if a single stock has a high CAPE ratio.

The Buffett Indicator

Also known as the Market Cap to GDP ratio, the Buffet Indicator calculates the market cap of all public companies in a country (across all indexes), divided by the gross domestic product (GDP) of that country.

This is related to a high level accounting practice known as the price-to-sales ratio, zoomed out to encapsulate an aggregate of all stocks versus the total output of that economy.

Generally, a reading of greater than 1 standard deviation is considered highly valued, whilst a reading of -1 standard deviation is considered ‘cheap’. As you can see, not the most sophisticated measure of valuations, but it does serve as a ‘back of the envelope’ approach to tell you if you need to dig deeper into if markets are in a bubble.

Source: Current Market Valuation

Markets are currently in “strongly overvalued” territory for the United States, over 200% of total market cap versus GDP as of July 2021. Again, if you look at this index you may think that U.S stocks are overvalued at current levels.

Bubble, Bubble, Cauldron Trouble

When prices are pushing record-highs as they are today, it is tempting to call a bubble at the exuberance of it all.

But what the prior two indicators do not show you is the context and sentiment surrounding prices, there is no mention of liquidity in CAPE or the Buffet Indicator. This is why potentially these two indicators are almost best to be used as one of your last checks, not your first.

Looking back to the start of this note, one of the key indicators of each stage of a bubble cycle is sentiment, something that these two metrics do not show.

Perhaps it’s the case that bubbles are best identified by how the market is reacting, how those irrational agents are talking and how they interpret data and news.

If the traditional bubble cycle is to believed, the “boom” may not be so dangerous, there is plenty of room to go and we have not reached that point of “irrational exuberance” that former US Federal Reserve Bank President Alan Greenspan was so fond of mentioning.

The trick is to know when we have reached the abandonment of reason known as “euphoria” and when the time to exit is – that is the multi-billion dollar question, and since there aren’t that many billionaires out there, that may be a harder trick than it seems.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.