Are You Bubble Blind?

Everyone is vulnerable to bubble blindness. The majority of investors never see them coming and won’t be able to identify an asset bubble until it is in their rearview mirror. Hindsight – as they say – is 20/20. And of course, by then it is too late. They have already been soundly clobbered.

When walking out of a dark building on a sunny day, the brilliance of the sun “blinds” you momentarily. It is not until you find your sunglasses that you can take in your complete surroundings. Similarly, dazzling returns on the stock market blind most people to the full economic picture.

You need to look at the markets through the tempered lenses of time and patience to fully understand what is happening. Only then can you prepare and protect your portfolio.

The Fed as a Bubble Blowing Machine

The Federal Reserve was put in charge of our nation’s monetary policy in 1913 with the Federal Reserve Act to smooth the business cycle, but it accomplished the opposite.  With the same act, the dollar took a step back from its gold backing in the name of monetary elasticity. But it is not too hard to understand why these two moves drastically worsened the market’s boom and bust cycles.

Under normal market conditions, interest rates are a signal of the availability of capital. Interest rates are the price of money and the laws of supply and demand apply. When capital is abundant, natural interest rates go down, encouraging the assumption of more risk and potential growth, because the market is in a position to absorb losses. When capital is more restricted, interest rates go up, signaling a risk-averse environment that seeks to preserve capital. High interest rates are a signal to pay down debt and shore up capital reserves. A healthy economic ecosystem naturally regulates itself in this way and makes risk and debt more expensive in times when more caution is needed. 

The Fed’s interest rate policy typically does exactly the opposite of what the market would do organically. It lowers rates when the economy is unhealthy and raises them when it is strong. Thus, the Fed becomes a bubble blowing machine, sending confusing economic signals, exacerbating business cycles and encouraging malinvestment.

Low interest rates push a tidal wave of money out into the economy at precisely the wrong times. This money is out there in search of investment vehicles in a weak market, bidding up assets well beyond what they are reasonably worth.

That is where we are now. If you look at indicators like the Shiller P/E ratio you can easily see that a wave of capital has been pushed into unworthy assets. Those investments will not be able to continue to perform as investors hope. 

This is classic bubble territory and we have been here for a while. How much longer can it last?