What Are Market Bubbles? [And How to Identify Them]

Understanding bubbles is one of the most important things an investor can learn, because getting the bubble phase right (and knowing when the machine is working in reverse) is often the difference between compounding wealth and watching it disappear.

Bubbles are a classic feature of the archetypal big debt cycle. They form when credit growth starts running faster than income growth, when asset prices get disconnected from the cash flows underneath them, and when the psychology of “it’s different this time” takes over from sober analysis of what an asset can actually earn.

They always end the same way. The question is only when, and how ugly the unwind will be.

The most classic bubble dynamic was that credit was created and borrowed to buy assets. Credit creates debt that had to be paid back, so when the money needed to service the debt was greater than the money produced by the assets, the financial assets had to be sold. This caused them to fall in price, and the bubble dynamic worked in reverse to make the bust dynamic.

That is the template. Everything below is a variation on it.

Key Takeaways – What Are Market Bubbles? [And How to Identify Them]

• Bubbles form when debt grows faster than income. This pushes asset prices beyond what underlying cash flows justify.
• Early bull markets are healthy; bubbles start when borrowing becomes unproductive but still inflates prices.
• Low interest rates = higher asset prices (stocks, real estate) because future returns are discounted less. In the real world, when cash and non-credit risk assets yield less, this causes more capital to flow into risk assets.
• Psychology matters: FOMO, herd behavior, and “this time is different” thinking drive late-stage bubbles.
• Warning signs: high valuations by conventional measures, heavy leverage, easy credit, new/inexperienced investors.
• Bubbles usually pop when rates rise or credit tightens, making debt harder to sustain.
• The unwind is self-reinforcing: falling prices -> forced selling -> deeper declines.
• Big crashes (e.g., 1929, 2008) come from system-wide leverage and debt concentration.
• How to stay immune from bubbles = have a balanced portfolio that diversifies well.

Asset bubbles like a game of Monopoly

If you think of the game Monopoly, early in the game, there’s a lot of property to buy with cash. Players who land on properties, following the optimal strategy, usually buy them. Prices reflect what a player can actually pay out of pocket.

As the game goes on, more and more property gets bought up, rents rise, and players start mortgaging properties to keep buying new ones. Cash becomes scarce relative to the claims on it.

At some point, one player lands on a high-rent property, can’t pay, and starts selling assets at fire-sale prices to cover the bill. The game ends with one player holding everything and the others broke.

That’s the debt cycle in miniature. Credit expansion produces rising asset values and rising net worths. Rising net worths make everyone feel creditworthy, which makes them borrow more, which bids prices up further.

At some point, the claims on cash outrun the cash available to meet them, and the process runs in reverse. Assets get sold to service debts. Prices fall. Net worths fall. Creditworthiness falls. Lending contracts.

The “yield” on different asset classes

All assets compete with each other. To understand where we are in the cycle, start with the yields available across cash, bonds, and stocks, because those yields tell you what expected forward returns look like and what the risk premium is between one asset and the next.

Cash yields whatever the central bank’s short-term rate is. Bonds yield more than cash to compensate for duration risk. Stocks yield more than bonds to compensate for the fact that they’re perpetual cash flow instruments with higher structural volatility.

The “yield” on stocks is more difficult to determine because they don’t come with advertised rates like cash and bonds do.

Stocks convey ownership of a business that represents a residual value after everyone else has been paid. They’re perpetual cash flow instruments.

Historically, over the past 50-plus years, stocks have delivered an extra 2 to 3 percent annual return over 10-year Treasury bonds. That’s the risk premium.

When cash rates and bond yields are high, equity earnings yields are also high and P/E ratios are low. When cash and bonds yield close to nothing, the discount rate disappears and you’re left with just the risk premium.

The inverse of that 2-3 percent risk premium represents the price-earnings ratio: roughly 33x to 50x (1 divided by .03 and 1 divided by .02, respectively).

That is why traditional markers of value, like the 10x to 20x P/E ratios that investors became used to in earlier environments, are extrapolations of a world where yields were much higher.

In an environment where the cash yield is 5 percent and mid-duration safe bonds give you 7 percent, stocks would typically yield around 10 percent (10x P/E), keeping in line with typical risk premiums. In an environment where cash is zero and bonds are 2 percent, stocks might “only” need to yield 4-5 percent to be competitive, which pushes multiples up.

Same risk in absolute terms. Lower forward returns. That’s the trade-off investors face whenever cash and bond rates are compressed.

Portfolio assets’ performance: long-run history

These are broad long-run indicators. Circumstances vary considerably across decades. But the relationship between cash, bonds, stocks, and gold has held up as a rough guide for how these asset classes behave across different parts of the debt cycle.

Developed market bubbles vs. emerging market bubbles

Emerging markets

We published a series on trading the cycle in emerging markets.

The types of recessions we see in emerging markets are different from those in developed markets.

Broadly speaking, developed markets are countries with:

• reserve currencies
• stable political environments
• developed capital markets (debt and equity)
• strong rule of law
• respect for private property rights

Emerging market recessions tend to be inflationary. Developed market ones tend to be deflationary.

This is because of the effect of the currency dynamic.

Emerging markets tend to borrow in other countries’ currencies. When a recession hits and the currency declines relative to the one they borrow in, that’s like a big surge in interest rates.

Printing money to make up for the shortfall worsens the depreciation, which increases the costs of imports and typically leads to a contraction in supply relative to demand, pushing up the prices of goods and services (i.e., inflation).

Developed markets

In developed markets, recessions tend to be deflationary.

They heavily borrow in their own currencies, so they avoid the FX risk. When a downturn occurs, debt servicing exceeds income. Spending must be cut back, which is deflationary.

Countries that can “print” money will try to do so to offset the drop in credit.

Countries that can’t print money, or can only do so to an insufficient extent because they lack reserve currencies, will need to restructure their debts.

The bull market

In the early part of the cycle, incomes are growing faster than debt. Debt growth is robust, but still lower than income.

In these early stages of bull markets, there is a wide range of productive investments. So even though debt growth is strong, it’s used productively to produce income in excess of the debt.

If money is borrowed and it makes a business more productive by providing goods and services that grow revenue commensurate with such value, then debt burdens will remain low and balance sheets will remain healthy.

Given such an environment with quality forward returns, there is enough room for the private sector, financial system, and government to lever up.

When inflation is a reasonably low and stable percentage and debt growth is below or in line with income growth, this is a quality period for investments and justifiably produces a bull market.

The bubble phase

The bubble phase begins when debt growth is faster than income growth.

This is when debt produces income less than the sum of principal and interest payments. The debt growth becomes unproductive.

Yet rising debt growth still produces strong returns in assets, income, and overall economic growth. The price of financial assets is a function of money and credit spent divided by their quantity.

Even if the debt being produced doesn’t throw off the cash flow to make these debts viable, there’s a tendency to extrapolate the past and assume it’ll be like the future even when the underlying conditions change.

Higher debt produces rising net worths, incomes, and asset values. This perpetuates the process as borrowers become more creditworthy.

Creditworthiness is a function of:

• i) income and projected cash flow available (or likely to be available) to service the debt
• ii) existing savings and net worth or available collateral
• iii) the lender’s own capacity to lend capital (i.e., for banks, fintech, non-bank lenders, hedge funds, etc.)

All of these factors rise in tandem.

Borrowers will feel wealthier even when the underlying state of conditions changes from the “healthy bull market” phase to the “bubble” phase.

Debt growth is exceeding income growth yet they continue to buy assets at high prices on credit.

For example, assume someone makes $100k per year and has a net worth of $100k.

Let’s say they could borrow up to $10k per year, which means they could spend $110k per year for several years even though their annual income is only $100k.

This increased capacity for borrowing allows for higher spending. And a person’s spending can lead to higher income, higher asset valuations, and/or higher savings. This, in turn, gives them even more collateral to borrow against.

This causes people to borrow more and more, with this process quickly starting to resemble a cycle. When people borrow, they are not only borrowing from a lender. They are borrowing from their future self.

Eventually they have to spend less, invest less, and/or take less for themselves because they have to pay that money back.

So long as that borrowing helps drive economic growth and it produces more income in excess of the servicing, it’s affordable.

In the upswing in the debt cycle, the promises to deliver money (namely, debt burdens) rise relative to the money supply, economic growth, and all forms of liquidity available to borrowers to pay back their obligations (which come from incomes, new borrowing, and asset sales).

Central banks periodically adjust short-term interest rates to slow down or help pick up the rate of credit creation. This is the standard business cycle that most of us are used to and experience multiple times over the course of our lifetimes.

Many business cycles add up to a longer-term debt cycle that ends when short-term interest rates hit zero and can’t be pushed further.

Over the multi-decade arc of the developed-world debt cycle, each cyclical peak and cyclical trough in interest rates has generally been lower than the one before. Lowering interest rates increases the demand for debt and also raises asset prices and people’s wealth (through the present-value effect: lower interest rates lift asset prices).

Generally, this creates progressively higher debt levels relative to income and reduces the capacity to raise interest rates without triggering an intolerable drawdown in the economy.

Eventually, short-term interest rates hit zero and the capacity to push credit creation further via conventional policy can’t go on.

While the business cycle that we’re used to ends whenever the central bank hikes interest too far (usually to rein in inflation), the longer-term debt cycle ends when rates hit zero or a bit below zero and can’t be pushed down further.

The hitting of the zero lower bound usually occurs when:

i) debts become too large relative to the amounts that can be borrowed, and

ii) the debts become too large in relation to the money in existence

When the amount of money and credit coming in can’t rise relative to the need to service debt, the process works in reverse.

Investors need to deleverage. Borrowers default. Creditors pull back lending. The down part of the cycle begins.

Borrowing is a way of pulling forward spending. The person who spent $110k per year and was earning $100k per year now has to spend $90k per year for as many years as he spent $110k, holding all else equal.

This is the general dynamic that inflates and deflates a bubble.

How bubbles start

Bubbles typically begin as excessive extrapolations of justified bull markets.

Bull markets are justified when interest rates (i.e., cash rates) are low relative to the returns on stocks, credit, real estate, and other equity investments.

When asset prices rise, economic conditions improve. People become wealthier. Companies hire more. Corporate profits increase, which improves their balance sheets and ability to take on more debt. All of these influences cause companies to be worth more.

When asset prices go up, spending and incomes rise, as do net worths.

Business people, investors, banks and other financial intermediaries, and policymakers have more confidence in ongoing prosperity. This causes leverage in the system to increase.

The boom also encourages new speculative flows from new investors who fear missing out on the gains. This fuels the bubble further.

Anywhere from “sometimes” to “frequently,” governments adopt policies that encourage banks and other financial intermediaries to lend to those who are unlikely to represent profitable lending opportunities.

This encourages reckless lending and a buildup of bad debt within the system.

Credit standards being lowered are one of the hallmarks of a justifiable bull market turning into a bubble.

With new lenders and new speculators in the market, new types of unregulated investment vehicles develop. Non-bank lenders are collectively called the “shadow banking” system, which are also not subject to the same government protections.

New lending vehicles get created (peer-to-peer lending, private credit vehicles, new forms of structured products) and financial engineering occurs to generate higher prospective returns.

Lenders and speculators typically make a lot of money quickly.

This helps reinforce the bubble as higher net worths helps secure new or larger loans to buy even more assets.

While this is going on, most don’t believe it’s a problem.

People like it because they’re getting richer, or from the outside, they view it as a positive. Most assume it’s a productivity-driven boom. In turn, this causes the rise to feed off itself.

With stocks and other risk assets, rising prices lead to more investment and spending. This raises earnings, which in turn increases asset prices further.

This narrows credit spreads and incentivizes more lending due to higher earnings and more valuable collateral. That increases investment and spending in a self-perpetuating cycle.

Most people think the assets they’re buying are great to own and anyone who doesn’t is missing out.

All sorts of entities (institutions, retail, banks, etc.) build up long exposure to these assets.

Asset-liability mismatches increase in various forms:

• i) increasing liquid liabilities to invest in illiquid assets
• ii) borrowing short-term securities to invest in more volatile, longer-duration assets
• iii) carry trade exposure increases, such as borrowing in one currency to buy another that yields more
• iv) borrowing money from other people to invest in risky forms of debt and equity

All fundamentally rely on chasing some type of spread between prospective returns and the borrowing rate.

However, as asset prices are bid up, this narrows the spread. Capital market participants typically increase their leverage to achieve the desired return on equity, building further leverage into the system.

Debts rise and debt servicing costs typically increase even faster.

While the central bank is mostly concerned about inflation in goods and services, the inflation in financial assets is actually more insidious.

Goods and services inflation is viewed as a bad thing because it increases the cost of living and creates lower disposable income at a certain point. Financial asset inflation appears like a good thing and it isn’t prevented.

It’s just as bad as any other form of indebtedness.

A financial asset represents a securitization of a cash flow. In order for the asset to justify its valuation, it has to earn the income to give you the earnings or cash flow you’re entitled to.

If booms are an effect of debt rather than productivity and not enough income is produced from this debt, asset prices become out of whack relative to the practical level of earnings they can generate.

Financial booms financed by debt typically come alongside periods of low inflation (often because low interest rates go hand in hand with low inflation, which incentivizes borrowing), even though they appear to be driven by productivity gains.

This was true in much of the developed world in the 1920s leading up to the 1929 bust, Japan in the late 1980s, and most of the world in the mid-2000s leading to the 2007-09 financial crisis. It was true of the post-pandemic everything rally that deflated in 2022 when rates normalized.

A case study: Japan, 1985 to 1990

Consider Japan in the late 1980s. Following the Plaza Accord in September 1985, the yen strengthened sharply against the dollar. The Bank of Japan cut interest rates aggressively to offset the drag on exports. Cheap credit went into Japanese real estate and equities.

By 1989, the Nikkei was trading at a P/E ratio above 60x. In other words, the forward one-year yield of Japanese stocks was less than 2%. Tokyo land was valued at more than the entire United States. The grounds of the Imperial Palace were said to be worth more than all of California. Japanese corporations were issuing convertible bonds at implied equity volatilities that made no mathematical sense. Banks were lending against collateral valued at bubble prices.

The broad Japanese economy looked healthy on the surface. Inflation was low. Employment was high. GDP growth was solid. None of the standard central bank dashboard lights were flashing red.

When the Bank of Japan finally tightened in 1989-90, the cascade was immediate. Equities fell more than 60 percent. Land prices eventually fell by similar magnitudes. Banks that had lent against inflated collateral found themselves holding loans worth a fraction of par. The result was more than a decade of deflationary stagnation, which is often called “the lost decade” (which stretched into two).

The mechanics were textbook: credit growing faster than income, asset prices extrapolating recent history, leverage chasing compressed spreads, a central bank focused on consumer price inflation rather than asset price inflation. The specifics were Japanese, but the cause-and-effect mechanisms were universal.

The overweighting and extrapolation of recent history

Markets are discounting mechanisms where they price in a weighted average of all opinions called a consensus.

This is generally considered a reasonable picture of what’s likely to happen even though the future is typically different from the past.

Humans tend to follow the crowd and emphasize recent experiences.

Asset prices going up often makes them seem like better investments rather than worse investments.

If we follow common behavioral patterns when it comes to a consumer good, a rising price typically makes us less likely to purchase it, not more likely. Financial assets flip that logic on its head.

Because the consensus is always priced in based on the capital flows that created those prices, inappropriate extrapolations of the past tend to occur.

At these periods, debts relative to income tend to rise very rapidly.

Bubbles are likely to occur near the top in the various cycles, whether this is the business cycle, longer-term debt cycle (i.e., when interest rates hit zero), and/or the balance of payments cycle (more common for emerging markets).

When the bubble nears its top, there are conflicting elements of the economy being the most vulnerable at the same time people feel the wealthiest and most bullish.

Debt to income ratios commonly average around 300 percent of GDP at the peak and is generally accompanied by a flattening yield curve (i.e., long-term interest rates coming down to short-term interest rates).

Monetary policy’s role

Oftentimes, monetary policy helps inflate the bubble rather than reel it in.

This is particularly true when inflation is modest and within acceptable limits, growth is at around expectations, and the returns on investment assets are solid.

This helps reinforce the optimism driving investors to buy financial assets on leverage.

Because central banks have statutory mandates to focus on limited frameworks (inflation, or inflation and growth) and not credit growth, they often don’t adequately tighten policy. This was responsible for Japan’s market dynamics in the late 1980s. It was true for US housing in the mid-2000s. It has been true in the post-GFC cycle of compressed real rates that inflated a wide range of asset classes.

The flaws in central bank policies often lead to these problems in the first place.

Central banks typically target a mandate of either:

a) inflation (i.e., price stability), or

b) inflation and growth (full employment within the context of price stability)

The implication is that they typically don’t place much attention on the debt growth that’s occurring to finance the creation of bubbles.

If growth and inflation don’t appear to be strong or the central bank is actively stimulating the economy, this can facilitate excess speculation in the financial economy with the hopes that some of that wealth creation will eventually get into the real economy.

A central bank is heavily responsible for all debt in an economy given their pulling on their levers influences incentives.

It’s important for them to keep debt growth at a reasonable level with a focus on keeping it neither too high nor too low relative to income (i.e., such that it can be serviced).

Some policymakers will counter this point saying that it is too difficult to ascertain whether a bubble is occurring, that “engineering” the financial markets is beyond their scope or duty, and that growth and inflation is their given mandate.

They control the amount of money and credit in an economy.

When that money and credit goes into debts that cannot be paid back or into risky assets whose earnings will never justify their valuations, that has big implications for growth and inflation down the line.

The biggest depressions occur when bubbles burst (e.g., 1929, 2008). If central banks are the ones producing the debt that inflates these bubbles and they won’t control them, who will?

The economic pain of a 1929 or 2008, or the various bubbles throughout history, is so high (and changes the economic, social, and political landscape of a country) that it is not sensible for central bankers to ignore them.

This is why a “credit growth in line with income growth” mandate is so important rather than merely managing the business cycle or the trade-off between employment and inflation.

When inflation runs above an acceptable level, it’s common for central bankers to raise short-term interest rates. But normal monetary policies of short-term rate adjustments are largely too broad and non-specific to sufficiently manage bubbles.

This is because bubbles often manifest in certain parts of an economy and not in others.

In the 1998-2000 period, it occurred in technology and internet companies. From 2004-08, residential housing became a problem. In the early 2020s, everything from growth stocks to crypto to SPACs to long-duration tech was bid up simultaneously.

Basic short-term interest rate adjustments are not usually appropriate for some sectors relative to others.

During this time, central banks are likely to fall behind the curve. Some borrowers may not be squeezed yet by the higher debt servicing costs.

When interest payments are typically being met through newly borrowed funds instead of income growth, EBITDA, or a similar earnings metric, this is a warning signal that the trend isn’t sustainable.

When the bubble goes into reverse, the same linkages on the way up (more borrowing leading to higher spending, leading to higher incomes, leading to more investment, which creates more valuable collateral and more borrowing) create the same downward spiral and become self-reinforcing.

Falling asset prices cause asset and collateral values to drop.

Since assets are typically bought on leverage, they often get squeezed out due to liquidity problems. Lenders pull back. Speculators need to sell. People have the increased need to raise cash to make debt payments and normal spending needs, so assets are sold off, which drives prices down even further.

Lenders and investors also take their money out of risky assets and financial intermediaries that may have built up leverage and bad debt problems from the run higher.

When these leveraging problems occur within key intermediaries or enough people are affected, this often becomes systemically threatening. That is, they can threaten the viability of the entire economy.

How to identify bubbles

After previous bubbles, regulatory measures often help clean up the problems where they occurred.

The high-profile Enron and Worldcom accounting frauds helped spur the Sarbanes-Oxley Act to help improve the transparency of corporate accounting.

The housing problem and the buildup of subprime mortgage debt within large commercial banks saw response with the Dodd-Frank Act and Federal Reserve stress tests.

The specifics differ across cases. The size of the bubble is different. It affects different asset classes and different industries. The nature of the bubble popping is different (slow deflation, violent burst), and so forth.

That said, the nature of bubbles is such that they are more similar than different and they can be understood by looking at their cause-and-effect relationships.

Knowing what to look for and having a mental picture of what they are makes it easier to identify them.

While there are overall markets that may be in bubbles (either at the economic, sector, or even specific asset level), there are also second- and third-order effects of bubbles popping.

The 2008 financial crisis had a bubble in subprime housing.

The knock-on effects of that eventual collapse were based on who held exposure to that debt, which were primarily the commercial banks and those of lower and middle incomes who were brought into the housing market and would lose their homes.

They were leveraged in such a way that made the potential insolvency of some systemically threatening to the entire economy.

It’s important to know who’s connected to the bubble. If you take a common example of a bubble in a single stock, you might look at how a bursting of that kind of bubble would impact those who hold its equity and debt, and whether any of them are systemically important.

The defining features of a market bubble

Bubbles are most commonly identifiable due to:

1) Prices being high relative to traditional measures. If stocks have a forward earnings yield of two percent, a rise in inflation or normalization in real rates could compress their multiples and hurt the most leveraged companies.

2) Prices are discounting high levels of earnings that aren’t likely to be justified.

3) Purchases of assets are commonly done with high leverage.

4) Bullish sentiment is broad (e.g., few bearish investors, survey data showing extremes).

5) There is a wave of new buyers in the market who are inexperienced, speculating on assets they don’t understand well, don’t know how to price, are driven by narratives and groupthink rather than a careful analysis of future earnings potential, and riding the wave on the most popular assets.

6) Monetary policy is stimulative and pushing asset prices higher.

7) Buyers are making extended purchases of goods such as supplies and inventory to either speculate or help insulate themselves from future price gains.

A modest tightening in monetary policy or in longer-duration bond yields would threaten the bubble.

A rise in yields impacts the assets that are the most overvalued and those with lower quality balance sheets, which makes them vulnerable to being squeezed. This is what happened to long-duration growth stocks in 2022 when yields normalized: the most overvalued parts of the market saw 50-80 percent drawdowns while more modestly valued assets held up better.

Investors can measure the estimated duration of the assets they own and what a modest tightening in monetary policy would do to its price.

If an asset has a forward yield of two percent and is a perpetual cash flow instrument (i.e., a stock), that means its earnings multiple is the inverse of that, or 50x.

A one percent rise in rates could potentially cut the value of the asset in half, multiplying that one percent by the effective duration of the asset.

Multiple metrics must be considered when assessing a bubble

Any one metric is not a reliable indication that a debt crisis or “popping of the bubble” is at hand.

Debt to income, while a common way of looking at the health of an economy, is not reliable because it ignores the debt servicing component. But even debt-service payments relative to income is not adequate either.

To know what’s going on, one has to get at the specific debt-service requirements of individual entities. Looking at the averages is not enough because problems that exist or are emerging in specific entities are lost by looking at broad metrics.

A high level of debt to income or debt-servicing requirements relative to income is not as problematic if it’s distributed across the economy.

When it’s concentrated in certain sectors (or even companies), that is where systemic problems can emerge. This is particularly true if they are large or concentrated within key entities.

2008 and commercial banks

2008 was a bad crisis because the subprime mortgage problems were concentrated within large over-leveraged commercial banks.

If those banks failed, that would mean people losing access to their money, their money market accounts, brokerage accounts, lending services, and so forth.

While it is socially and politically controversial to save imprudently managed companies, the costs of not saving them are higher than the costs of saving them.

How policymakers respond after a bubble pops

Once a bubble pops, policymakers reach for a predictable sequence of tools. Understanding this sequence matters because it determines what happens to your portfolio in the aftermath.

Broadly, there are three types:

#1 Interest-rate policy

The central bank cuts short-term rates to stimulate borrowing and spending. This is the standard tool and works well when rates have room to come down. MP1 stops working when rates hit zero.

#2 Quantitative easing (QE)

The central bank creates reserves and uses them to buy financial assets, pushing up their prices and pushing risk premiums down. MP2 helps when MP1 is tapped out, but it has diminishing returns: it works through asset prices and therefore mostly helps those who already own assets. Eventually you run out of risk premium to compress.

#3 Fiscal and monetary policy coordination

Next is putting money more directly into the hands of spenders. This typically requires coordination between the central bank and the fiscal authority: the government spends or transfers money to households, and the central bank finances it. 

This is what gets reached for when rate policy and QE have both run out of gas. It was the playbook of the post-pandemic response in 2020-21.

Alongside these monetary tools, deleveraging a debt bubble classically requires pulling on four levers:

1) Austerity (spending less).

2) Debt defaults and restructurings (writing debts down or off).

3) Debt monetization and money printing (the central bank creating money to buy debt).

4) Wealth transfers (redistributing from those who have to those who don’t).

Each lever has different effects. Austerity and defaults are deflationary and painful. Money printing and wealth transfers are inflationary and politically contentious.

The key is to get the mix right, so that deflationary forces are balanced with inflationary ones. When policymakers move the levers in a balanced way and the nominal growth rate can be kept marginally above the nominal interest rate, debt-to-income ratios fall without crushing the economy.

When policymakers get the mix wrong, you get either a prolonged deflationary depression (US 1930-33, Japan post-1990) or a runaway inflation (Weimar Germany, Latin America through various cycles).

History suggests those who did it quickly and well, like the US in 2008-09, got far better outcomes than those who did it late, like the US in 1930-33 and Japan in the 1990s. In the end, money printing is pretty well inevitable. The question is only how long they wait before they do, and how much damage compounds in the meantime.

What a popped bubble means for different asset classes

Asset classes behave in recognizable ways across the phases of the cycle. I’m providing these only as broad indicators, since circumstances vary considerably. The key is to understand the mechanism.

Stocks

Stocks typically peak a few months before the broader economy rolls over. In the early stages of a bubble bursting, when stock prices fall and earnings have not yet declined, people mistakenly judge the decline to be a buying opportunity and find stocks cheap relative to both past and expected earnings. They typically are not.

As the credit contraction works through to corporate earnings, the second leg down tends to be deeper than the first. Historically, equity declines in deleveragings average around 50 percent. (This was the case in 2008, though in 1929 the fall was around 88 percent peak to trough.)

Bonds

Bonds split into two camps. Government bonds of reserve-currency issuers tend to rally hard in the deflationary phase as market participants flee risk. Corporate and high-yield bonds, by contrast, get hammered: credit spreads widen sharply, the interest rates on risky loans go up, and debt that was priced for benign conditions starts to look stressed.

Cash

Cash looks appealing in the early stages of the bust, because it holds its nominal value while other assets fall.

But holding cash through the full cycle tends to be punishing. Once the central bank moves to QE and coordination with fiscal policy, real cash yields typically go deeply negative.

So the main risk is a loss in buying power, not nominal price risk.

Gold and real assets

Gold and real assets tend to perform well when the central bank is forced to monetize debt. Currency weakness, especially against gold, is a common feature of the late-stage deleveraging. This is one reason many argue for a structural allocation to gold as a store of value.

Inflation-indexed bonds

Inflation-indexed bonds are an underappreciated asset class in this environment. They protect against the exact outcome that large debt monetizations tend to produce.

Implications for portfolio construction

The implication for portfolio construction is not to try to perfectly time the bubble top. Nobody does that reliably. The implication is to hold a mix of assets that can perform across different economic environments.

Some assets do well when growth is rising. Some do well when growth is falling.

Some do well when inflation is rising. Some do well when inflation is falling.

A balanced portfolio (often called balanced beta or risk parity) is built around that simple observation: uncorrelated return streams across the four possible combinations of growth and inflation (rising/falling growth/inflation – relative to discounted expectations).

Being positioned for all of them beats trying to guess which one is next.

What causes asset bubbles to pop?

No specific event or shock typically causes a stock market bubble (or any type of bubble) to burst.

They commonly burst due to the influence of higher interest rates.

Classically, bubbles develop because rising prices require buying on leverage to keep accelerating at an unsustainable rate.

Both lenders and speculators end up near or at their maximum positions, and tightening changes the economics of the leveraging-up process.

Systemic problems in non-traditional entities

While traditional lending institutions are commonly sources of these problems, they do occur in other entities as well.

Long-Term Capital Management was a hedge fund (part of the lightly regulated non-bank “shadow banking” system) that became systemically important to the global financial system in the late 1990s by making relative value trades with high leverage.

The original core strategy of the fund relied on trades predicting the convergence of the spread between “off-the-run” and “on-the-run” bonds in fixed income futures markets.

Because the spread involved in most relative value and arbitrage trades is so small (particularly in the case of true arbitrage trades), the fund leveraged up many times to generate the high annualized returns (over 40 percent) in its first few years.

Because LTCM was successful at exploiting these relative value and arbitrage opportunities, and the intellectual capital of their team was so high (it included Nobel Prize winners, among many other accomplished people), more investors wanted to invest with them.

This caused their assets under management to grow at the same time these opportunities were being arbitraged out of the market, both by themselves and other competitors looking to copy them.

They were on the forefront of investing at the time and any valuable opportunities with reasonable margins to them attract competition regardless of the business.

To obtain their desired results, they increased their leverage and were forced to allocate capital to second- and third-tier ideas. They entered markets and trades that were beyond the initial scope of their expertise.

They went into strategies such as merger and acquisition (M&A) arbitrage, and standard long and short directional bets. They also applied strategies to less liquid emerging markets after previously focusing mostly in more liquid developed markets.

Going into 1998, even though the firm’s assets under management were around $5 billion (high, but not uncommon), its notional exposure to the markets was well over $1 trillion (200x-250x leverage).

In the late 1990s, that was over 10 percent of US GDP at the time.

When leveraged 200x, a mere 50-bp swing in the fund’s equity position would effectively wipe out the entire capital base.

In the summer of 1998, markets were volatile due to the fallout from currency crises in developing Asian markets from the year before, and Russia was nearing a point where it would have to devalue its currency and eventually default on its debt.

Salomon Brothers, one of LTCM’s counterparties, decided to exit the arbitrage business entirely. This caused a widening in the spreads of LTCM’s trades with less liquidity in those markets.

Russia’s problems led to a reduction in “risk on” trades and a flight into global safe haven assets (US Treasury bonds, gold, yen). This caused a further widening of the spreads on LTCM’s relative value and arbitrage trades.

Due to a confluence of factors where the markets were not acting on the basis of sound fundamentals, LTCM’s losses began to stack up.

Because of the size of the fund’s positions, compounded by its imprudent use of leverage, liquidating them was not feasible.

The fund’s counterparties also began to understand the scope of LTCM’s problems, which meant their own problems.

This, in turn, led to the hedging of counterparty risk specific to themselves. This dispersed LTCM’s issues to more and more entities in the financial system and led to even worse problems for LTCM itself.

To avoid default and potential systemic issues for the economy at large, the Federal Reserve Bank of New York stepped in to negotiate a bailout package with LTCM’s creditors.

While LTCM had assembled an incredible team of very intelligent people, it illustrates the severe inadequacy of bad assumptions in risk management, such as the inappropriate use of using the past to inform the future.

Markets are not like a game of chess where you can look at what worked in the past, or what can work based on a fixed set of rules within the context of a closed system, and expect it to work like that in perpetuity.

That type of extrapolation can be logical where you know previous environments will work exactly like future environments.

The financial markets are not like that. They’re an open system not constrained by a fixed set of variables.

Market history is rife with ostensibly low-probability events that occurred due to inaccurate estimations of their actual probabilities.

If you become a material portion of your market, that can become a problem because of the liquidity premium associated with that.

Similar to the concept of cornering a market, when anyone becomes a material part of one’s markets, the possibility of getting squeezed gets higher.

The recurring case of single-name bubbles

A recurring feature of developed-market bubbles is the extreme valuation of individual companies or narrow themes that come to represent the “future” in investor imagination.

Take a hypothetical stock trading at $500 billion in market capitalization with $25 billion in revenue. That’s 20x revenue. To justify that valuation, shareholders would need to be paid 100 percent of revenue for 20 straight years just to recoup their principal.

That assumes zero cost of goods sold, which is impossible for most real-economy businesses. It assumes zero operating expenses. It assumes zero taxes paid at the corporate level. And it assumes no capital expenditures and no research and development for the next 20 years.

Those assumptions are all of course non-viable. That is why it rarely makes sense to buy a slice of a business at extreme valuations unless the idea is to join “the greater fool game” and speculate in the market in the hopes of trying to sell it at a higher price.

Single-name bubbles are most dangerous when the company has become so large that its market cap represents a meaningful share of national GDP. That makes it systemically threatening in some form.

If a mega-cap bubble deflates, the residual effects cascade through the economy via those with exposure to its equity and credit, the index funds that hold it at heavy weights, and the lending relationships built around it.

While those who have long exposure to a bubble enjoy the ride on the way up, it’s just like any other form of indebtedness.

People, especially those with leveraged exposure, get squeezed on the way down with no economic income available to justify the valuation.

What they think is an asset isn’t actually an asset at all, but rather simply a conduit for speculative activity.

Quantitative easing and asset bubbles

When a central bank embarks on quantitative easing, it is effectively creating more money and pumping it into the economy.

This extra cash can cause asset prices such as property and stocks to rise. This increase in asset prices can reach the stage of a bubble where further price increases are not likely.

Asset bubbles can have harmful effects on an economy.

When the bubble eventually bursts, those who have bought assets at inflated prices can find themselves significantly out of pocket. This can lead to a sharp fall in consumer spending, which can in turn lead to recession.

While asset bubbles may be difficult to avoid entirely, central banks can take steps to manage them and mitigate their effects.

One way of doing this is by using macroprudential policy: regulation and supervision targeted at specific risks in the financial system.

Banks may be required to hold more capital against mortgage lending, which can help to prevent a build-up of debt and limit the potential for house prices to spiral out of control.

When asset prices become too high, central banks can also take direct action to bring them down.

This might involve selling assets from their portfolios (quantitative tightening) or raising interest rates.

By doing this, central banks can reduce the amount of money in the economy and help to avoid inflationary pressures.

Does the occurrence of asset bubbles mean investors are irrational?

Yes, it’s an example of irrational behavior. But they occur for predictable reasons and many traders even try to profit off them, knowing that a bubble is forming a potential quick profit opportunity.

It is important to remember that asset prices are determined by the collective actions and expectations of all market participants.

While some individual investors may be irrational, it is also possible for asset bubbles to form even when most investors are behaving rationally.

Asset prices can be driven by factors such as herd behavior, where investors buy assets simply because others are doing so, or because there is simply too much liquidity being produced and it’s going into all sorts of assets, overvaluing everything.

If cash and bonds yield close to nothing and perhaps negatively in real (inflation-adjusted) terms, this can make entire large asset classes unattractive.

This then drives people into stocks, real estate, private equity, cryptocurrency, NFTs, SPACs, algorithmic stablecoins, and other forms of speculation.

Even if you can accurately identify an asset bubble it can be hard to turn that realization into winning trade ideas.

As the old saying goes: “the market can stay irrational longer than you can stay solvent.”

How do asset bubbles cause recessions?

Asset bubbles can cause recessions via a negative wealth effect.

If people buy assets at high prices, and especially buy assets at high prices on leverage, the fall in price can be devastating to a lot of people.

Leverage magnifies both gains and losses.

If prices fall by 50 percent, a person with no leverage loses 50 percent, which is bad enough. A person with 2x leverage loses 100 percent.

Asset bubbles and credit constraints

Credit constraints are an important factor that can amplify the effects of asset bubbles.

If people can only borrow a limited amount of money, then they won’t be able to buy as many assets even if prices are rising.

If credit conditions loosen, for example if banks start lending more money or if the government makes it easier to get a mortgage, then people will be able to buy more assets, which can drive prices up further.

Asset bubbles and monetary policy

Monetary policy can have a big impact on asset prices, both directly and indirectly.

The most direct way that monetary policy affects asset prices is through interest rates.

If interest rates are low, then it will be cheaper to borrow money, which can lead to more buying of assets such as property.

Low interest rates tend to lead to higher stock prices, because they make it cheaper for companies to borrow money and because they reduce the returns from alternative investments such as bonds.

Indirectly, monetary policy can also affect asset prices by influencing the growth of the economy.

If the central bank cuts interest rates in order to boost economic growth, this can lead to higher asset prices.

What are the most famous asset bubbles?

The most famous asset bubbles include Dutch Tulip Mania in the 1630s, the South Sea Bubble in 1720, the 1929 US stock market bubble, Japan’s late-1980s bubble, the dot-com bubble of the late 1990s, and the US housing bubble of the 2000s.

The dot-com bubble was driven by irrational exuberance around the potential of internet companies.

Many investors were willing to pay high prices for shares in these companies regardless of whether or not they were actually making any money.

Stock prices soared to unsustainable levels before eventually crashing back down to Earth.

The housing bubble was driven by a similar phenomenon, with many people buying homes at ever-increasing prices, often with borrowed money.

Prices reached unsustainable levels and then came crashing down, leading to a sharp increase in foreclosures and a deep recession.

Asset Bubbles – FAQs

What happens when an asset bubble bursts?

When an asset bubble bursts, the price of the asset falls sharply and quickly.

This can cause people to lose a lot of money and can lead to economic problems.

What causes an asset bubble?

Asset bubbles are often caused by too much money chasing too few assets.

This can happen when there is a lot of investment capital looking for somewhere to go.

They can easily develop when there are low interest rates and easy credit, which encourages people to borrow money to buy assets.

What are the consequences of an asset bubble?

The consequences of an asset bubble can be serious. When an asset bubble bursts, people can lose a lot of money.

This can lead to economic problems, such as recessions or depressions.

Asset bubbles can also cause financial crises, such as the housing crisis in the United States and other countries in 2008.

What are some examples of asset bubbles?

There have been many examples of asset bubbles throughout history.

Some notable examples include the stock market bubble in the United States in 1929 and the late 1990s, the housing bubble in the US in the early 2000s, and the commodities bubble in 2008.

How can I protect myself from asset bubbles?

There is no guaranteed way to protect yourself from asset bubbles.

There are some things you can do to reduce your risk.

You can diversify your investment portfolio so that it includes a mix of different assets.

You can also pay attention to economic indicators to try to identify when an asset bubble might be forming.

If you are thinking about investing in an asset that has seen a sharp increase in price, you should be aware of the risks involved and be prepared for the possibility that the price could fall sharply.

How do you identify an asset bubble?

There is no sure way to identify an asset bubble. There are some warning signs that an asset bubble might be forming.

These include rapid price increases, high prices by traditional indicators (e.g., high P/E ratios), high levels of debt, lots of new buyers entering a market, and low interest rates.

If you see these warning signs, it’s important to be cautious before investing in the asset.

You should also be aware of the risks involved in investing in assets that have seen a sharp increase in price.

How can a central bank identify an asset price bubble?

A central bank can use a number of methods to try to identify an asset price bubble.

These include looking at the price of the asset, economic indicators, and financial market data.

If a central bank suspects that an asset price bubble is forming, it may take steps to try to stop it from growing.

The central bank might raise interest rates or impose restrictions on lending.

Central bank policy is often too broad to target bubbles directly.

This is because asset bubbles often develop in certain pockets of an economy but not others.

For this reason, macroprudential policies are often used that can be much more targeted.

What are macroprudential tools?

Macroprudential tools are policy measures that can be used to help reduce the risk of financial crises.

They are often used to target specific risks, such as asset price bubbles.

Some examples of macroprudential tools include capital requirements, loan-to-value ratios, and credit growth limits.

What is monetary policy?

Monetary policy is the use of interest rates and other tools by a central bank to influence the economy.

It is often used to manage inflation and economic growth.

What is fiscal policy?

Fiscal policy is the use of government spending and taxation to influence the economy.

It is often used to manage economic growth and debt levels.

Should central banks consider asset prices when making policy?

The economic pain of allowing a large bubble to inflate and burst is very high, so it can be easily argued that it is not prudent for economic policymakers to ignore them.

It’s not always obvious when an asset bubble is forming and is often mistaken for new innovation or growth, so it is often hard for central banks to know when to act.

There is also the risk that if central banks try to deflate a smaller bubble, they might unintentionally cause a recession.

For these reasons, many economists believe that central banks should only take action to deflate an asset price bubble if it is very large and poses a serious threat to the economy.

How do bubbles affect the economy?

Bubbles can have a number of different effects on the economy.

They can lead to higher levels of debt and inflation.

They can also lead to economic instability and even recession.

In some cases, bubbles can also have a positive effect on the economy.

They can lead to new innovation and growth.

The risks associated with asset bubbles are usually greater than the potential rewards.

This is why it’s important to be aware of the risks before investing in an asset that has seen a sharp increase in price.

Does quantitative easing create asset price bubbles?

Quantitative easing is a policy that is often used by central banks to increase the money supply.

It is often used during times of economic difficulties, such as when short-term interest rates are low and inflation is low.

Some people believe that quantitative easing can lead to asset price bubbles through its ability to overstimulate economies.

What are the risks of investing in an asset that has seen a sharp increase in price?

There are a number of risks associated with investing in an asset that has seen a sharp increase in price.

These include the risk of the asset price bubble bursting, the risk of inflation, and the risk of recession.

Before investing in an asset that has seen a sharp increase in price, it is important to be aware of these risks.

Why are asset prices not included in inflation?

Inflation typically means the rise in the prices of goods and services.

Asset prices are not included in inflation because they do not directly affect the prices of goods and services.

Asset price bubbles can indirectly lead to inflation by causing an increase in spending via higher wealth.

What is the difference between an asset bubble and inflation?

An asset bubble is a situation where the price of an asset rises sharply and then falls back down over a period of time.

Inflation is a sustained increase in the prices of goods and services.

Asset bubbles can lead to inflation, but they are not the same thing.

What are the risks of a housing bubble?

A housing bubble is a situation where the prices of houses rise sharply and then fall back down over a period of time.

The risks of a housing bubble include the risk of default, the risk of foreclosure, and the risk of inflation.

Before investing in the housing market, it is important to be aware of these risks.

What happens when an asset bubble bursts?

When an asset bubble bursts, the prices of the assets involved fall sharply.

This can lead to a rapid loss in wealth for many and recession.

For this reason, it is important to be aware of the risks before investing in any asset, especially assets that may suddenly become “hot”.

Why are asset price bubbles not sustainable?

Asset price bubbles are not sustainable because the prices themselves reflect unsustainable conditions.

If a stock discounts high future growth and this growth cannot be realized, then the stock at some point will need to fall.

Speculators at a point will become leveraged long and adopt max positions that cannot be sustainably increased.

Bubbles can also form around assets whose prices are low relative to their fundamental value.

Investors and traders may buy these assets, driving up the price, but eventually they will realize that the asset is not worth what they paid and sell it, leading to a sharp price decline.

Conclusion – Asset Bubbles

Asset bubbles occur when the price of an asset rises sharply and then falls back down over a period of time.

They can lead to inflation in goods and services and eventual recession due to the misallocation of capital they can create.

In this article, we covered the lead up and signs of a market bubble as they typically apply to developed market economies.

(For emerging market economies, which typically have inflationary recessions, we covered this in more detail here.)

In the next part of this series we will cover the markings of a market top and how the cycle plays out from that point forward.

What to do with this

Bubbles are one of the few features of markets that recur with enough regularity that traders can prepare for them. They’re not perfectly predictable in timing, but they are predictable in pattern.

A few takeaways worth internalizing.

First, watch credit growth relative to income growth. When credit is growing materially faster than income for an extended period, the economy is in the bubble phase regardless of what headline growth and inflation look like.

Second, pay attention to who is buying and with what. New, inexperienced buyers using leverage to chase assets they don’t know how to  value from the ground up is a warning signal. It has been a warning signal in every bubble going back to tulips.

Third, remember that the most vulnerable assets in a popped bubble are the longest-duration, most richly valued ones. If you own a stock at 50x earnings, a one percent rise in rates relative to what’s discounted into the forward curve can roughly cut its value in half. Duration cuts both ways.

Fourth, don’t try to short bubbles at the top unless you have deep pockets and a long time horizon. As the saying goes, the market can stay irrational longer than you can stay solvent. It’s generally easier and more profitable to reduce exposure and wait than to actively bet against the mania.

Fifth, diversify across asset classes that respond differently to different growth and inflation environments. You don’t need to call the top of the bubble correctly. You only need a portfolio that survives it.

Part II: Characteristics of a Market Top