According to The Economist, investors do not seem to be worried about an asset bubble, much less a crash. Standard & Poor, a credit rating agency, stated that in advanced economies, the negative bias (i.e. number of bond issuers with negative outlooks) is “at a multi-year low”.
Ask Jeremy Grantham, one of the investors who predicted the dotcom boom, and he disagrees entirely. Grantham states, in his publication “Bracing Yourself for a Possible Near-Term Melt-Up (A Very Personal View)” that “a melt-up or end-phase of a bubble within the next 6 months to 2 years is likely, i.e., over 50%”.
However, the economy currently shows none of the usual symptoms of a bubble. According to The Economist, Grantham’s own firm sees an annual loss of 2% from American large-cap equities (in fact, the firm sees that, out of all asset categories, only cash and emerging market equities will produce a positive real return). Furthermore, the Purchasing Managers’ Index (PMI) which measures the economic health of the manufacturing sector, indicates that the global economy is improving. As well, according to The Economist, we have yet to see “signs of the kind of late-stage acceleration in share prices that marked American shares in 1929, and 1999/2000 or Japan in 1989.” The biggest sign of a bubble that people watch for, euphoria, is also missing.
In the previous article, I outlined Shiller’s hypothesis that bubbles are exacerbated by euphoria, driven by the media. Consider the cyclically adjusted price-earnings ratio (CAPE), which measures how expensive stocks have become. CAPE suggests that the economy is in a bubble, as it has only been this high twice before: once, during the dotcom bubble; and once during the 1929 bubble. Accompanied by this bubble, we would expect to see euphoria. Today, however, there is no euphoria, and the media is not exacerbating booms and busts. Why don’t we see euphoria?
According to Grantham, perhaps looking at the usual signs of a bubble will not do us much good. He argues that “we have to reconcile to the fact that no two bubbles, even the classics, are the same. They share the fact that there are many signs of investor euphoria, sometimes indeed approaching the madness of crowds, but the package of psychological and technical indicators has been different each time.”
So, what is different with this bubble, compared to previous ones? Usually, euphoria is linked to a certain asset, such as tech stocks during the dotcom bubble, or property prices during the GFC. However, we see a bull market for almost everything: from stocks, to bonds, to property. They are all expensive compared to their long-term averages. In this situation, it is hard to pinpoint a rise in one asset; resultantly, euphoria cannot take off the same way it did in previous economic bubbles. Consider three assets that are in a bubble: stocks, equities, and property.
The Economist argues that stock prices do not reflect their intrinsic value. CAPE tells us the price of stocks and the extent of overvaluation. Purchasing stock is essentially purchasing a share of profits in a company. Since 1881, the average CAPE for S&P 500 was 17. Now, it is 30. Therefore, The Economist argues that “buying a stream of profits is currently uncommonly expensive”. This increase in asset prices is being accompanied by riskier investments that investors do not fully understand any more than mortgage-backed securities (securities that consisted of sub-prime mortgages).
The Economist also notes that equities around the world are also increasing rapidly in price. The S&P 500 index rose by 13% in 2017, which was almost matched by European and Japanese stock markets. European and emerging-market economies’ stock valuations are not as unreasonably high as American ones, but are unambiguously above their long-run averages.
The Economist states that property is also overpriced. In Australia and Canada, two countries who managed to avoid the worst of the GFC, house prices are much higher than their long-run averages, relative to the cost of renting. In America, house prices have risen back above their 2008 peak in nominal terms. They, too, are higher than their long-run average relative to rents. In Britain, there is a similar situation: property prices are nearly at their peak, in terms of average earnings and rents.
We see an asset bubbles in more areas than just stocks, bonds, and equities, such as in credit spreads, according to The Economist. These spreads are the difference between the interest rate offered by safe bonds such as US Treasuries, and by riskier ones, such as bonds issued by companies. According to The Economist, they measure “how much compensation investors require to bear the extra risk”. This spread has narrowed dramatically: people are more willing to take risk for less reward. The Economist points out that in 2016 January, when oil prices sank below $30 and investors predicted a crash in the Chinese economy, the spread for investment-grade bonds was 2.2 percentage points. Now, it is 1 percentage point, which is only slightly higher than the pre-Global Financial Crisis boom. We see a similar story with high-yield or junk bonds.
To make profits, investors look for bonds that are denominated in dollars, but are issued by countries other than America, often emerging-market economies. The Economist argues that the spread between dollar-denominated US bonds and emerging-market bonds has decreased dramatically to 3.1 percentage points in 2017. The Economist continues by pointing out that these bonds bear extremely high risk: in June, many people purchased a dollar-denominated bond issued by Argentina that matures in 2117, despite the fact that Argentina has defaulted six times in the last century, most recently in 2014.
The price increase is not just confined to public markets. The sudden increase in the price of stocks and bonds pushes investors towards private markets, thus pushing prices up there too. The Economist states that investors are particularly looking to funds with a technology bent. For example, SoftBank, a Japanese telecoms company with sideline in venture capital, has raised $93bn from asset managers to be put into young technology firms.
Slice it any way possible, and it is hard to deny that the global economy is in an asset bubble. It is not unreasonable to see another crisis on the horizon in the case of wrong policy reactions to this asset bubble. Central banks must tread the line carefully and concoct a policy that deflates this bubble without pushing the economy into a crisis. In the next article, I will explore the role of central banks in financial crises.