Most investors have already lived through two severe asset bubbles, so with stock markets again at all-time highs and valuations looking stretched it’s understandable that they are looking for the next bubble that could be endangering their recent gains. Even if you think the bearishness is unwarranted and that the claims of a forming bubble in biotech, sovereign wealth, credit or any other asset class are unwarranted, recognizing risky behaviors now can forestall problems down the road.

Financial Crisis

Lets not forget the 2007 financial crisis

“The world today is awash with liquidity, stock market indices are at all-time highs, bond yields remain at all-time lows, volatility is astoundingly subdued, unemployment is approaching pre-crisis levels, and productivity appears to be on the upswing,” write Jefferies CEO Richard Handler and executive committee chair Brian Friedman. “However, let’s not completely forget the summer of 2007.”

Handler and Friedman identify three factors that are fully under investors control and play a big role in determining who gets into trouble during a bubble: leverage, style drift, and culture.

Leverage and style drift become problems as managers chase returns

Ultra-low bond yields, which may be around for many years, and high client expectations make the use of increased leverage almost inevitable. But what seems like a necessity today sets the stage for big losses in the future, and Handler and Friedman warn that we should have ‘our eyes wide open’ about the amount of risk coming back into the financial system. Even for individual investors, paying attention to the role that private debt is playing in determining asset prices can be a key to spotting trouble on the horizon (the difference between a Minsky moment and run of the mill high valuations).

In a similar vein, managers who need to justify their fees don’t want to be restricted to a small corner of the market. But branching out during a bull market can offer false confidence as questionable investments pay off, and there is a risk of managers becoming comfortable with financial instruments they don’t really understand.

Companies should have zero tolerance for ‘bad actors’

“Our final point is probably the one that is most important for not falling back into some of the bad behaviors that can lead one to be especially vulnerable during a crisis: Culture,” write Handler and Friedman.

They argue that arrogance, political infighting, and excessive risk-taking both flourish in the run up to a financial crisis and inevitably bring it about, while a lack of transparency makes these problems all the more difficult to address. Handler and Friedman believe that companies should aggressively take advantage of strong markets without putting capital at risk, and maintaining this balance is only possible if the right corporate culture is kept in place.