A lot of clients ask me: When is the bubble going to pop? What is the next bubble on the horizon? How do we prepare for the next bubble?
My question back to them is always: Do you know what a bubble is and how it works?
A bubble, in the financial and economic sense, is a fast rise in an asset's price followed by a contraction. Bubbles typically happen when the price of an asset is not justified by the asset itself but rather by the over-exuberant behavior of investors. When there are no more investors willing to pay the overinflated price, people panic and sell and the bubble bursts.
We have seen countless examples of this over decades of economic events in the United States. Heck, even in the last 15 years we've seen multiple bubbles.
- 2005: An asset bubble occurred in real estate. Hedge fund managers created a huge demand for credit default swaps that insured mortgage-backed securities which then created a demand for the mortgages that backed them. To meet this demand for mortgages, banks and mortgage brokers offered home loans to just about anyone and bended the rules around making such large loans. These subprime mortgages became all the rage and eventually, when housing prices fell, the asset bubble burst and a domino effect led to the banking credit crisis in 2007 and eventually a full global financial crisis in 2007.
- 2017: Bitcoin rose 955%, eclipsing the rise of any previous asset bubble. While Japan's Financial Services Agency recognized Bitcoin as a legitimate payment method, helping to artificially inflate the digital currency, the price of Bitcoin was not justified because Bitcoin was not widely accepted as a form of currency yet. People panicked once Bitcoin seemed to become stagnant and sold out of their shares, leaving the long-term investors holding the bag when Bitcoin came crashing down.
There are five stages of a bubble to know:
- Displacement: Investors get enamored by a new technology or by an economic event like interest rates being low.
- Boom: Prices rise slowly but then really gain momentum as more and more participants enter the market, setting the stage for the boom phase. A lot of times the asset in question attracts widespread media coverage.
- Euphoria: During this phase, fear of missing out starts to hit the average investor and he or she throws caution to the wind and invests without any direct knowledge of how the asset works. Valuations reach extreme levels. Think the Japanese real estate bubble in 1989 or the Dot Com bubble in March 2000.
- Profit Taking: The smart money - with the ability to know the warning signs - is generally selling out of their positions and taking profits.
- Panic: Asset prices reverse course and descend as rapidly as they ascended. Investors and speculators that hadn't sold out yet now panic to get out at any price they can to liquidate what they have. The most recent large example of this is the global financial markets in 2008. In a single month, global equity markets lost $9.3 trillion of their combined market capitalization.
One industry on my radar for a bubble in the future is auto loans. At the tail-end of 2017, Americans had $1.238 TRILLION in car loans. The average length of a loan on a new vehicle purchase went from 65.5 months in April 2013 to almost 70 months in 2018. Consumers feel they are getting extra time to pay off the loan but in actuality they are paying more interest. At the end of June 2018, the US auto loan delinquency rate of 90 days or more was 4.17% as compared to 3.92% in June 2017. If this tendency increases in the next year, lenders such as commercial banks and finance companies will see severe losses on their income statement and get stuck with new vehicles they must desperately sell in order to raise cash. This could also have a domino effect on asset-backed securities such as bonds that have vehicle loans backing up the instrument.
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