Home Business IMF Working Paper Suggests Dual Criteria For Spotting Bubbles

IMF Working Paper Suggests Dual Criteria For Spotting Bubbles

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Mention asset bubbles and everyone know, more or less, what you’re talking about – asset trading at unreasonably high levels. But get into specifics and the consensus quickly falls apart. Depending on who you ask a bubble could be defined by prices that can’t be justified with any amount of future cash flows; price multiples to far above historical means; the presence margin debt to fuel price growth; or just simple herd mentality. And that’s just the definition, outside of a recession you can always find some people who claim there is a bubble and others who will deny it.

“This paper proposes a conceptually straightforward surveillance approach based on two distinct though complementary pillars: one that is price-based (capturing swings in risk premia or required returns), and another that is quantity-based (tracking issuance, transaction volumes, investor fund flows, and investor surveys,” writes Brad Jones in the IMF working paper Identifying Speculative Bubbles: A Two-Pillar Surveillance Framework.

two pillar asset Bubbles framework 1114

Asset bubbles: Using multiple criteria as a warning, instead of a definition

The idea is that, instead of trying to say with certainty whether there is an asset bubble, policy makers can use the two pillars to check when the threat of there being a bubble is high. Jones shows that risk premia fall to low levels in the months before major busts in every major asset class, while volumes tend to peak at the same time as prices. If both signals show up, he says that policy makers need to be especially vigilant because an asset bubble may be forming.

Bubbles risk premia before busts 1114

Bubbles equity trade volumes around booms 1114

US high yield debt is especially frothy

“An unusual feature of the current cycle is that the return required by investors to hold each major U.S. asset class is simultaneously below average, writes Jones, adding that, “the asset class that appears most stretched relative to fundamental anchors (and its own history) is low grade U.S. corporate bonds.”

It’s not news to most of our readers that high yield US corporate debt is trading well below historical average spreads, but Jones points out that many grades are actually below the level needed to survive an average default cycle, let alone another shock. High yield bondholders are setting themselves to take a beating if the next business cycle is relatively painless. If the weak US recovery backpedals, either from the end of QE or something else, high yield debt looks to be one of the first asset classes that will get wiped out. Whether or not you would define it as a bubble, Jones is probably right that it deserves policymakers’ attention.

us high yield possible bubbles 1114

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