Citi Analyst Rob Buckland published a diagram of the
potential bubbles that are brewing in the credit and equities market. He sees markets
moving into Phase 3 where unhealthy optimism is taking hold and people are
failing to adjust to early signs of bubbles. If we continue to our course
without adjusting and understanding where these bubbles are they will grow and
potentially burst forcing the economy to reverse course. You may see his chart HERE.
The phases are:
Phase 1: End of recession, interest is low and
stocks are low.
Phase 2: Stocks rise in a bull market and credit
speeds economic activity.
Phase 3: Stocks are high, credit risks hedge,
unhealthy optimism in stocks, early signs of bubbles show.
Phase 4: Low credit reverses value of stocks, credit
and equities fall, lower company profits that cause a recession.
Economic bubbles are part of the boom and bust cycle
of the economy. Economics define a bubble as an asset that’s prices can no
longer be justified by the value of the dividends expect to earn (Barlevy,
2007). People pile their investment monies into the bubble with high
expectations raising the price beyond its real value.
Real value being based on its practical utility,
costs, and additive value associated with the product itself. This is different
from the perceived value as defined by market interest. A house may have a
certain real value as a dwelling of construction materials but may be sold at
double or triple that value due to easy credit and market interest. If people
decide the cost of purchase is no longer worth it to them the value plummets and
investors lose money.
On a wide scale this could impact markets in a heavy
way across a broad range of economic sectors. We only need to view the last
recession and how homes were sold beyond the value that any reasonable person
would be willing to pay for them causing debt to skyrocket. Irrationality was
the mainstay of the day as broad sectors of society were buying and
pushing the price upwards with little consideration of its true value.
Bubbles can be found and predicted with logistic
functions and models that help see the change in irrational value (Ekonominiu,
et. al., 2009). Many of these models are
based on statistical analysis that predicts that irrational value increase are
beyond the inherent value of the product. They can use various market
indicators in associated sectors to determine one sector’s value is out of
place.
At present there is no perfect way to predict a
bubble but it is possible to be forewarned of a bust whenever irrational optimism
has taken hold, critical thinking of investors is low, and investment capital
is piling into a market sector that hasn’t seen substantial infrastructure and
technological improvements to support the increased value. The best hedge against bubbles is
to diversify a portion of your capital into unrelated sectors that counter market direction when busts occur.
Barlevy, G.
(2007). Economic theory and asset bubbles. Economic
Perspectives, 31 (3).
Ekonominiu,
B. et. al. (2009). Formation of economic bubbles: causes and possible
preventions. Technological & Economic
Development of Economy, 15 (2).
