There Is No Such Thing As an Isolated Bubble

Updated on

Valuation-Informed Indexing #227

by Rob Bennett

Articles in the investing advice literature refer to “bubbles” all the time. All investors know in at least a vague way what is being referred to when they see a reference to the word. But the full reality is that our knowledge of what bubbles are and how they operate is today poor.

People often speak of bubbles in different asset classes as if they were entirely different things. Many blame the bubble in real estate as having been a primary cause of the economic crisis while failing to blame the far bigger bubble in equities. People speak as if there could be a bubble in real estate without there being a bubble in stocks or a bubble in stocks without there being a bubble in real estate. Or as if there could be a bubble only in art or only in gold or only in antique cars.

Bubbles are not asset-specific.

There is no such thing as an isolated bubble.

To understand why, you need to understand what a bubble IS.

A bubble is the product of investor irrationality. Nothing more, nothing less.

Do you know which under-the-radar stocks the top hedge funds and institutional investors are investing in right now? Click here to find out.

There never can be a rational bubble. “Bubble” is a word we use to signify an insane amount of mis-pricing. Rational investors price assets properly. It is only by being irrational on a large scale that we can create bubbles.

Once our irrationality has created a bubble in one asset class, what is to stop it from creating a bubble in other asset classes? Nothing. Bubbles are like cancer. They always spread.

There were no separate bubbles in real estate and in stocks. It was the same bubble that ruined both markets. The real estate bubble played a role in causing the economic crisis. But the equity bubble played a far bigger role. That’s because it was bigger. People used the Pretend Gains in stocks to justify larger bids for real estate. The stock bubble spread to real estate.

It is in the nature of bubbles to eventually ruin every asset class. Investors fool themselves into believing that profits earned in an asset class suffering from a pricing bubble are real. Money is fungible. So people use money generated by one bubble to inflate prices in other asset classes. Once this process gets going, it is impossible to stop it except through price crashes. And of course the more asset classes there are that are infected by the bubble, the greater the number of crashes there are that are needed to restore reasonable prices.

None of what I am saying here makes sense under the conventional model for understanding how stock investing works (The Buy-and-Hold Model).

The conventional understanding is that investors can reduce the risk of owning stocks by devoting a portion of their allocations to bonds. But if bubbles eventually infect all asset classes, there comes a time when all the asset classes are priced to crash at the same time. Diversification is a powerful, positive force. But the negative power of bubbles is great enough to counter it.

This even happens with virtually risk-free asset classes like Treasury Inflation-Protected Securities (TIPS) and IBonds. TIPS and IBonds were paying amazing returns (4 percent real) when the stock bubble was at its height. Fantasy thinking about stocks was so great that it took a return that great to win investor interest for these reality-rooted investment classes. TIPS and IBonds were not suffering from bubble pricing in those days. Asset classes infected by a bubble pay low returns. That 4 percent return for two super-safe asset classes represented a once-in-a-lifetime opportunity.

Look at how things have changed. I have spoken to many investors who are skeptical about the long-term value proposition of stocks at today’s prices who are not willing to lower their stock allocations because the safe alternatives to stocks offer such low returns today. There was even a time a few years back where the real return on TIPS threatened to enter negative territory. THAT’S bubble pricing. Those crazy prices came into effect because people became so worried about stocks as a result of the 2008 crash that they fled to the super-safe asset classes as an escape and thereby pulled their returns down to crazy low levels.

Today we have a situation where there are bubbles in both the risky asset class (stocks) and the non-risky asset classes (TIPS, IBonds, and certificates of deposit). In 2000, investors had their foot on the accelerator. We wanted stocks, stocks and nothing but stocks. Today, we have our foot on both the accelerator and the brake at the same time. We still love stocks; prices are lower than they were in 2000 but still at levels that would be considered bubble-level prices at any time in U.S. history except the late 1990s through 2008. But we also are scared to death of stocks, scared enough to lower the price of stocks from where it was in the early 2000s and to pull the return on the safe asset classes down to very low levels. The cancer has spread so much that there is no longer any escape from it.

There is no end to bubbles except through crashes. And, since bubbles eventually spread to all asset classes, crashes that affect only one asset class are generally not strong enough to kill the cancer; it often takes multiple crashes to pop all the bubbles. Attempts to pop just one bubble cause the irrationality to increase elsewhere. Then it returns to the asset class targeted by the popping effort once it is possible for it to do so.

I don’t want to close on a discouraging note. We don’t need to let bubbles grow so large as to threaten the continued viability of our economic system. Irrationality is oxygen for a bubble. We can stop bubbles by talking openly about them and by warning investors of the dangers of investing in asset classes infected by them. But that’s something that is far better done before mis-pricing has grown to the size at which we begin using the word “bubble.” People have a hard time hearing that they have made irrational investing decisions. Tell them that they have engaged in small bits of irrationality and they can take it. Wait until you have a bubble of irrationality on your hands and it is hard to gain a footing with rational arguments.

Rob Bennett recorded a RobCast titled The Politics of Investing. His bio is here.

Signup to ValueWalk!

Get the latest posts on what's happening in the hedge fund and investing world sent straight to your inbox! 
This is information you won't get anywhere else!