Mechanics of Asset Bubbles

This is my 250th post on this blog. Thank you for being kind and patient readers.

Barry Ritholtz has a post titled Checklist: How to Spot a Bubble in Real Time | The Big Picture. He puts across a list of conditions that we can watch to spot bubbles. While I agree with the post as a whole I would like to make some modifications to it from investor's thinking point of view. Barry himself is an investor so the end objective of the post is same as mine, to find opportunity to make money.

Let us delve into the mechanics of asset bubbles. All bubbles eventually burst. To understand nature of bubble burst however we must understand bubbles. The nomenclature "bubbles" is misleading when compared to their bursting behavior. Asset bubbles are more like balloons rather than bubbles. Some deflate gradually, some burst open when pricked by risks, others inflate to the point of no return. It is important for investors to identify the bubble and understand when it may burst.

Asset bubbles have three central elements. First being spotting inflating asset prices. The second refers to spotting risks that may cause bubble to burst. The third refers to spotting the timing of bubble bursts. Barry's post deals with all three however, I believe, they are mixed up in his list. 

Spotting possibilities of bubbles

To know if there is a possibility of a bubble we need to consider a few indicators:

1. Standard deviation of valuations: As standard deviations increase beyond 2, we should start considering a possibility of bubbles.
2. Elevated returns: The returns in the markets are high and, more importantly, consistently high. The consistency bit is a flag.
3. Unusually low volatility: The low volatility is another, albeit important, side of consistency in high returns. Volatility is an indicator of doubt. It indicates how much the market believes in higher asset prices. Higher volatility indicates that markets are testing the reasonableness of prices. It may be possible to have reasonably consistent annual returns but  still have high volatility throughout the year. 
4. Robust trading volume: It is difficult to imagine a healthy increasing volumes accompanied by low volatility but such conditions do exists during bubble period. The number of houses bought, number of people who trade in equity markets, etc.
5. Increase in employment: Driven by the bullish forecasts the bubble-prone sector goes into a hiring overdrive.
6. Increase in credit growth: Credit is a measure of low-risk-seeking capital. When all investors think the sector is low-risk quantum of credit flows to the sector increases seeds future bubbles.

Risks to bubbles

While above indicators reveal the possibility of a bubble, they do not specifically indicate the risks that may cause the bubble to burst. The risks emerge from causes of bubbles to their effects.

1. Perverse Incentives: These are difficult to track down before the burst but is eventually obvious. A diligent investor needs to understand the "why" behind the behavior of participants in that sector.
2. Unintended consequences: The frontiers of regulations (or de-regulations) often harbor seeds of bubbles. The problem with regulations in particular is that it can be reversed in a spur-of-the-moment decision by relevant authorities leaving investors in the lurch.
3. Excess Leverage: As the popular opinion of low-risk permeates through the financial world, firms are encouraged to take on more debt increasing their leverage. Increasing equity prices also puts pressure on management to deliver high returns. Managers rejig the capital structure to increase return on equity for the same return on capital. The easiest way to achieve this is by increasing leverage.
4. New products: Barry refers to only financial products however any product that teases regulatory acceptability can create risks. Financial products are more potent because they tend to affect multiple sectors and economy as a whole. Naturally, financial products have been at the forefront of biggest bubbles in history.

Understanding timing of bubble bursts

A few behaviors are prominently visible during the late stage of bubble formations. Typically,

1. Declining credit spreads: While I am using Barry's headings, the central idea he points to is bigger than credit spreads. During late-bubble phase, the price or yield or return distribution and risk distribution do not match. In normal times, higher risk implies lower prices and higher-but-volatile returns expectations while lower risks implies higher prices and lower but more stable return expectations. In other words risk-return equations become asymmetrical.
2. Declining credit standards: This is another face of risk-return asymmetry we discussed above. Firms with strained balance sheets get easy access to credit. It also indicates lower default rates on credit side and further acceleration in credit growth in the sector. The latest credit investments may be difficult to recover and hence are as good as write-offs.
3. Tortured Rationalizations: Almost all bubbles have advocates who have strong beliefs that they validate using unverifiable, anecdotal but mismatched data or new metrics that have no history. Be it eye-balls, estimating number of millionaires as proxy for premium housing demand, etc.
4. Trading volume spike: We note that high and steadily increasing volumes are marks of bubbles but accelerating volumes - spikes - indicate that end is near.
5. Interest rate changes: A credit-driven bubble is sensitive to interest rate changes. However, the sector may not react at the turn of interest rate policy. So when the central bank raises rates after a long cycle of declining rates, there seems to be no effect on the bubble sector. It is after two or three rate hikes that suddenly things start to fall apart.

While spotting bubbles is difficult, the difficulty can be reduced. Bubble-spotting is iterative process and takes a while to establish the conditions for bursting of bubble.

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