Looking for Bubbles Part Two: A Sentimental Approach

Edward Chancellor

“It is important for the Fed, as hard as it is, to try to detect asset bubbles when they are forming,” Janet Yellen, the Fed’s prospective new boss, told the Senate Banking Committee last November. At the time, and later when she reappeared before the same committee in late February, Yellen did not see speculative “excesses [as] having developed at this point.” To justify this claim, Yellen suggested back in November that U.S. stocks weren’t particularly expensive relative to analysts’ estimates of future earnings – a notoriously unreliable measure of market value.

Perhaps because they are new to the game – researchers at the U.S. central bank were not allowed to discuss the “b-word” during Greenspan’s tenure – the Fed appears to have trouble identifying bubbles, ex ante. Typically, at GMO we call a bubble when an asset has moved two standard deviations from its long-term real price trend. This approach would have identified the 1929 bubble, the Nifty Fifty boom of the 1960s, and the Dotcom mania in the late 1990s.

The purpose of this essay, however, is to take a non-valuation approach to bubbles. I outline the typical features of asset bubbles, as they have appeared over the ages, and look at a number of measures of market sentiment. I conclude that most of the conditions under which earlier bubbles have appeared are present in the U.S. markets today.

Furthermore, many of the traditional measures of market sentiment, such as the soaring performance of IPOs, appear to be indicating excess. This all bodes ill for long-term investors in U.S. stocks.

Typical Characteristics of a Stock Market Mania

Edward Chancellor: This-time-is-different mentality.

Throughout history, successive market manias have been rationalized with the argument that history is no longer a reliable guide to the future. Both the “new era” of the 1920s and “new paradigm” of the 1990s were marked by a “this-time-is-different” mentality. The same mode of thinking is evident again today. U.S. profit margins are currently at peak levels and the profit share of GDP in the United States is more than two standard deviations above its long-term mean (based on data going back to the 1920s). The U.S. profits dataset is the most reliably mean-reverting financial series available, claims Andrew Smithers of Smithers & Co. Most commentary, however, assumes that U.S. profits have reached, in Irving Fisher’s immortal phrase, a “permanently high plateau.” As John Hussman of Hussman Funds comments, “Believing that historical tendencies have evolved into a new paradigm will likely have the same results as playing leapfrog with a unicorn.” Painful.

Edward Chancellor: Moral hazard.

Speculative bubbles tend to form when market participants believe that financial risk has been underwritten by the authorities. The “Greenspan Put” appeared in the late 1990s after it became clear that the Fed was prepared to support falling markets but wasn’t going to act against the bubble in technology stocks. Fed policy hasn’t significantly changed since then. Monetary policy in the aftermath of the financial crisis has aimed to put a floor under asset prices, encouraging investors to take on more risk. As a consequence, U.S. household wealth – comprising largely of home equity and stocks – has rebounded to a near-record level of 472% of GDP, nearly 100% above its long-term mean. Whenever a cloud appears over Wall Street, market participants have come to expect more quantitative easing and guarantees of perpetually low interest rates. The personnel may change at the Fed, but the Greenspan Put remains in place.

Edward Chancellor: Easy money.

Great speculative bubbles have generally been accompanied by periods of low interest rates. Greenspan’s easy money policies in the last decade inflated the U.S. housing bubble, along with numerous other bubbles around the world. Bernanke’s cure for the economy in the wake of the financial crisis has been more of the same.

Full article via GMO

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