Posted By: Matthias Paul Kuhlmey
Those “bubble men” in New York’s Central Park are quite impressive. If you have seen them, creating gigantic, soapy elements between two rather large sticks, you get the idea: Bubbles are hard to predict, especially directionally, not easy to form (until they do), and rather messy, especially right at the end. “Bubble,” according to some market observers, is one of the most overused words related to 2013 Wall Street jargon. In fact, as early as 2009, Forbes magazine issued a “ban on bubble[s]” from the financial dictionary, but without much success, as we know today.
Beating Forbes magazine by seven years, in 2002, then fairly-new FED Chairman, Ben Bernanke, put his very own ban on bubbles, dismissing a Central Banks’s ability to identify inflated (bubbly) assets. The topic, overused or not, doesn’t seem to get old. Today, numerous market observers fear the existence of a bubble in asset markets, but especially in U.S. Equities, notably: Ben Inker, from GMO, claims a +75% overvaluation for the S&P 500; Professor Robert J. Shiller (the same guy who correctly predicted the U.S. Housing bubble) calculates the adjusted 10-year average of earnings over prices, resulting in a PE ratio of more than 1.3 standard deviations above the long-term average since 1880; and, last but not least, seasoned investor, Marc Faber, is convinced that “we are in a gigantic financial asset bubble” that now can “burst any day.”
There is, however, some good news, and our three amigos (as above, not counting Ben) may just want to relax. A recent study finds that, based on advanced econometric methodologies, bubbles in asset prices potentially can be detected. Applying this new approach to historic data of the S&P 500, only during nine episodes did equity prices deviate from fundamentals – but(!) most certainly not this time around. The conclusion (quite different from above) is that the probability of the S&P 500 currently trading in a bubble comes to only 20-33%. Nevertheless, this doesn’t mean we can simply sit back and relax: considering current market dynamics under the new research methodology, the S&P 500 could very well reach bubble territory in 2014. Think “Central Park” for visualization!
The vivid debate over bubbly stuff cannot clearly be decided, and, consequently, we need to be reminded of previously established disciplines to be applied as part of an overall investment process:
- Beware of the vibrant “headline” news; we are most likely being told “stories of convenience.”
- Should a “story of convenience” prove to be inaccurate, beware of volatility in markets.
- As economic conditions continue to be “subpar,” accommodative policies will exist (QE).
- With further increases in the global monetary base, asset price inflation will continue.
- It will be important to distinguish “inflated assets” from those that rise on good valuations.
- As long as Central Banks keep easing, equity markets will have a “floor” … and so should bonds!
- Central Banks will “take turns”: After the U.S., it is now Japan’s turn. Europe (likely) will be next.
- No country can afford a strong currency (competitive devaluation). Identify future stores of value.
Don’t turn greedy and “chase” markets. Manage volatility. Understand risk-adjusted returns.