Key Questions: What Causes Bubbles To Burst?

George Mateyo, Chief Investment Officer, February 2021

Key Questions: What Causes Bubbles To Burst?

Conditions for a bubble to build are apparent. Conditions for a bubble to burst are not — yet.

In prior essays, we described how certain conditions that existed during periods in which asset bubbles were created are again apparent. Of these conditions, there are three that commonly surfaced: Interest rates were at or near zero; central banks assured the markets that interest rates would remain low for an extended period, forcing investors out on the risk curve; and an abundance of liquidity. These circumstances are evident today.

For bubbles to fully inflate, ultra-accommodative monetary policy and excess liquidity are usually combined with new tools to democratize or expand investor participation, new era theories to justify overextended valuations, little regard for risk, and unbridled enthusiasm. These elements are also present today.

To wit, many investors are focused on a company’s TAM – Total Addressable Market – as a way to highlight a company’s immense potential instead of focusing a company’s existing assets, an approach historically used to determine the value of an enterprise.

Similarly, online trading — now completely frictionless— has surged in popularity and has been propelled even further via social media. And through the creation of SPACs (special purpose acquisition companies, also known as blank check companies), companies have new sources of capital that generally appear less discerning relative to the past.

Meanwhile, another massive shot of fiscal stimulus from Congress appears likely to arrive at a time when vaccinations are ramping up and the Federal Reserve (the Fed) has vowed to let the economy run hot, thus injecting further amounts of liquidity. In short, bubble-like conditions are present and visible across many asset classes, including stocks, high-yield bonds, real estate, commodities, and other types of investments.

At the same time, however, conditions for a bubble to burst are not apparent (yet), and therefore we continue to suggest that investors maintain a slight overweight to risk assets relative to safe havens. But given the levels of certain assets, investors should anticipate bouts of volatility, exercise sound judgment and selectivity, and consider owning diversifying strategies that are beyond traditional investments to enhance one’s overall portfolio.

History is replete with asset bubbles inflating and then bursting, beginning as far back as 1637 and extending into the modern day. Five notable bubbles occurred in the last five decades: the Nifty-Fifty bubble in the 1960s, the gold bubble in the 1970s, the Japanese bubble in the 1980s, the technology bubble in the 1990s, and the housing bubble in the mid-2000s.

Corporate fraud, financial abuse, and other misdeeds were factors that caused some bubbles to burst. But one other commonality existed across all episodes: rising interest rates and a tightening of liquidity manifested in the form of an inverted yield curve — a phenomenon where short-term interest rates are higher than longer-term interest rates.

We should note that attempting to time a bursting bubble is a fool’s errand; some asset bubbles collapsed immediately after interest rates start to move higher, while others persisted until the very end of a rising interest rate cycle. To be clear, an inverted yield curve is an important signal. But while the bursting of asset bubbles has occurred when the Fed lifted short rates above long-term bond yields to trigger an inverted yield curve, not every yield curve inversion has led to a precipitous decline in asset values.

Despite legitimate concerns today over expanding asset bubbles and while certain assets appear overdue for a correction, we don’t believe a major burst in asset prices en masse will occur in the near term. This is simply because the Federal Reserve has committed to keeping interest rates low and the yield curve is steepening rather than inverting. Historically, this is an environment where asset bubbles are built rather than burst.

That said, for those who are mindful of market volatility and hyper-sensitive to temporary drawdowns, preserving some cash to deploy in a major decline might be beneficial. For most investors, however, adhering to one’s policy portfolio is usually a winning strategy over the long run. Importantly, such plans already incorporate the expectation of episodes of volatility and need to be maintained for their ultimate success to be realized.

We also advocate for modest tactical tilts relative to one’s strategic asset allocation targets. These include some slight overweights to small cap and cyclical stocks and a slight underweight to large cap growth stocks. As a convenient reference point, we have been favoring equal-weighted indexes versus capitalization-weighted indexes in order to increase exposure to smaller and more cyclical companies.

In addition, as 2021 began, we recommended adding to non-US stocks as we noted these shares would benefit from an expanding global economy. We also observed that they were cheaper and possessed more cyclical exposure relative to their US counterparts. We maintain this view.

Lastly, we recommend investors consider owning diversifying strategies, or strategies beyond traditional investments to enhance one’s overall portfolio. Such strategies may be classified as real assets and stand to benefit from a stronger global economy.

In sum, conditions for an asset bubble are present, but conditions for asset prices to burst are not. Still, investors should be prepared for rising volatility by exercising selectivity, employing certain tactical tilts, and incorporating a broad set of tools to improve the diversification of their overall portfolios.

For more information, please contact your Key Private Bank Advisor.

Publish Date: February 16, 2021.

Source: Is the Federal Reserve Fueling a Stock Market Bubble (January 25, 2021).

Any opinions, projections, or recommendations contained herein are subject to change without notice and are not intended as individual investment advice.

This material is presented for informational purposes only and should not be construed as individual tax or financial advice.

KeyBank does not provide legal advice.

Investment products are: