The S&P500 Index crossed the 2000-mark this past week, fueling more wonderment at the lofty levels of equity prices. As I explained in a recent op-ed, high prices may be telling us something new about innovation that we don’t already know. But in recent meetings with investors, business leaders, and academics, there remains an undercurrent of concern about bubble-like conditions in the markets. The dominant question is, “How do we know if we’re in a bubble?”
What’s a “bubble”?
You must start with the fact that “bubble” conveys a general notion of excessive pricing and irrational investing—but it lends no clarity or bright line to distinguish really dangerous conditions from benign optimism. Peter Garber notes “bubble …is a fuzzy word filled with import but lacking a solid operational definition….if we have a serious misforecast of asset prices we might then say that there is a bubble. This is no more than saying that there is something happening that we cannot explain, which we normally call a random disturbance. In asset pricing studies, we give it a name—bubble—and appeal to unverifiable psychological stories.” [ 1]
Thus, the absence of science about bubbles summons two rules for bubble-watchers:
· Humility foremost. You have no crystal ball. Therefore, one’s assertions—no matter how emphatically believed—must be tempered with respect for the enormous uncertainty surrounding them.
· Bubbles are best-known in retrospect. Alan Greenspan, Chairman of the Federal Reserve, with all the power and informational advantage of that office, was unpersuaded of a bubble in housing in the mid-2000s. His memoir is worthy reading, on the difficulty of identifying bubbles and of implementing policies to deflate them.
How do we know if we’re in a bubble?
In our book, The Panic of 1907, Sean Carr and I summarized some prominent attributes near the peak of a bubble in asset prices:
- Dramatic rise in prices reflected in aggressively high valuation multiples and transactions compared to historical averages.
- Buoyant demand for the assets: oversubscribed initial public offerings in equities, numerous participants in auctions for companies, natural resources, and real estate.
- Optimism about the sustainability of future price increases.
- Entry into the market by naïve, inexperienced, and unsophisticated investors. Bernard Baruch sold his stocks in early 1929 when he started receiving unsolicited stock tips from his shoeshine boy.
- Talk of a “new paradigm” rendering long-standing investment maxims invalid. Such was the case during the Internet boom. “This time it’s different” is one of the most dangerous attitudes in investing.
- Jumbo deals. These deals change the competitive landscape and/or frame of reference for investors. Travelers Insurance acquired Citicorp in 1998, signaling the end of the regulatory ban on universal banking. The audacity of jumbo deals serves to reinforce “new paradigm” thinking.
- Innovations in instruments, institutions, and markets. Leading up to 1907 were the creation of trusts, new national consumer-branded products, and the spread of the telephone, automobile, and household electricity. Joseph Schumpeter heavily emphasized the role of the inventor and entrepreneur in triggering new phases in economic cycles.
- Aggressive financing. Banks lower their credit standards to the benefit of borrowers who lots of cheap credit.
- Regulators and other watchdogs relax their monitoring of financial intermediaries and investor behavior.
- Positive economic news. A recent stretch of growth.
- Media hype and considerable popular interest. Rising prices, huge profits, jumbo deals, often to the benefit of Everyman and Everywoman, garner front-page stories.
Several of the items on this list don’t fit the bubble profile as of Labor Day weekend 2014: #10 (positive economic news/growth—few people believe the global economic fundamentals are terribly buoyant); #9 (relaxed watchdogs—the SEC, CFPB, and DOJ seem more rather than less active these days); #5 and #3 (new paradigm thinking and optimism really don’t characterize the investment buzz these days). Absent these points, conditions don’t yet look like a bull market stampede.
On the other hand, some genuine jumbo deals are recently completed or currently pending (#6: USAirlines/American, Valeant/Allergan, Burger King/Horton’s, Family Dollar/Dollar General/Dollar Tree). Global M&A volume is at a seven-year high—so is the global volume of initial public offerings.
And the value of subprime loans is growing, which may go hand-in-hand with the entry of new and inexperienced players in the markets. Recently, the New York Times reported “explosive growth” in the volume of subprime loans for the purchase of used cars.
And, as I discussed in the previous post, prices seem high relative to historical price/earnings ratios. Here’s one measure, favored by Warren Buffett, the market value of US Companies as a percent of the Gross National Product ( see more at Bloomberg).
Then, too, there is the concern about aggressive financing. While the whole economy may not feel growing indebtedness, some segments are booming—see the following graph on the call loan market, which fuels equity trading ( see more at dshort.com):
Watchful Waiting—and Learning
There is no substitute for vigilance toward bubble-like market conditions. But this doesn’t seem like one of those moments, just before the bursting of the dot-com bubble in early 2000 or the peak of the subprime bubble in 2007. Conditions could melt down for a variety of reasons, unrelated to the bursting of a bubble.
One helpful resource for paying attention to market conditions will be this year’s University of Virginia Investing Conference—November 13-14—the theme of which will be “Investing in Innovation.” Innovation is perhaps the most important foundation for growth, and PVGO. The conference will offer insights about growth prospects in fields such as information technology, energy, health care, and monetary policy. Once again, we are booking an impressive collection of speakers. As of today, speakers will include these (additional speakers are in the offing):
• Charles R. Cory (MBA ’82), Chairman of Global Technology Investment Banking & Managing Director, Morgan Stanley
• Richard Fisher, President & CEO, Federal Reserve Bank of Dallas (schedule pending)
• W. Barnes Hauptfuhrer (MBA/JD ’81), Chief Executive Officer, Chapter IV Investors
• Robert J. Hariri, Founder, Chairman & Chief Scientific Officer, Celgene Cellular Therapeutics
• Ned Hooper (MBA ’94), Partner, Centerview Capital
• Robert J. Hugin (MBA ’85), Chairman & CEO, Celgene Corporation
• Samuel D. Isaly, Managing Partner, OrbiMed
• Nancy Lazar, Partner, Cornerstone Macro
• John Siegel, Partner, Columbia Capital
• Michael Sola, Portfolio Manager, T. Rowe Price
• Kathy Warden, Corporate Vice President and President, Northrop Grumman Information Systems
Today’s financial market conditions are due to a blend of buoyant investor psychology and genuine growth opportunities. If so, this puts a high premium on thinking critically about investment themes, trends, and market sentiment. Conferences are one excellent means of sharpening your own thinking. Join us in November!
- Peter M. Garber, Famous first Bubbles: The Fundamentals of Early Manias, Cambridge: The MIT Press, 2001, page 4. [ ↩]