Bubbles

Authored by Jared Dillian via MauldinEconomics.com,

Bubbles aren’t new - they’ve been around since Dutch tulips - but it’s only recently that they’ve worked their way into the average investor’s lexicon.That’s probably because bubbles happen much more frequently these days.

We never used to get a giant speculative bubble every 7–8 years. But that has been the case since the new millennia.

In 2000, we had the dot-com bubble.

In 2007, we had the housing bubble.

In 2017, we have the everything bubble.

Why do we call it the everything bubble? Well, there is a bubble in a bunch of asset classes simultaneously (I delve deeper into this topic in my free exclusive special report, Investing in the Age of the Everything Bubble).

Let’s look at some of them.

Real Estate

You can spot real estate bubbles all around the world now. Canada, Australia, Sweden, Hong Kong, China—and California—to name a few.

Home prices in California have risen by 69% since 2010. Meanwhile, Canadian housing has shot up 1040% over the same period.

Why do these bubbles exist? For starters, ultra-loose monetary policy (which is also the reason that the bitcoin bubble exists).

What will be the catalysts that deflate these real estate bubbles? I’m not sure, but usually there isn’t a catalyst. The marginal house price just gets too expensive.

It seems pretty nutty that another real estate bubble is forming just ten years after the last one that nearly wiped out the planet. But real estate has been part of the food fight in asset prices and it appears to be peaking.

Cryptocurrencies

You have probably heard about the madness in cryptocurrencies, like Bitcoin, Ethereum, and ripple. Ethereum is up about 3,600% this year. As for bitcoin, it is old and boring and up only 343% this year. 

Alt-currencies are being launched left and right, in initial coin offerings (ICOs). These ICOs explode on the first day of trading, and everyone gets rich. Free money!

When people are making free money, you are pretty close to the end. These ICOs conjure memories of the IPO craze in 1999. That’s the funny thing about free money—everyone wants in.

Cryptocurrencies are a massive bubble because people are making money all out of proportion to their intelligence or work ethic, which is one of the hallmarks of a bubble.

Of course, you could just buy all these cryptocurrencies and ride the bubble. But I’m a little suspicious of buying just electrons or computer code—I like things with cash flows or that are tangible. Call me crazy.

Stocks

It’s also hard to get excited about companies that are generating cash flows. I hate to pick on FAANG stocks—at least they more or less make money—but these five stocks account for too much of the market gains.

Facebook, Amazon, Apple, Netflix and Google are responsible for over 30% of the S&P 500 index gain in market capitalization in 2017.

I talked about another rationale behind these stock prices back in June.

Still, investing in FAANG stocks is a fad like the Nifty Fifty was in the 60s. We may still be talking about the Nifty Fifty today, but nobody is investing in those stocks.

FAANG stocks are hard to short, because:

1.They are gifted and talented camps—companies whose sole purpose it is to hire the smartest people and turn them loose to solve hard problems.

2. They are passively engaged in surveillance.

3. CNBC talks about one of the FAANG stocks 90% of the time.

4. It is a frenzy.

But I assure you, the FAANG stocks will turn. These companies might be changing the world, but that’s not the point. They’re overpriced.

Credit Bubble

Likewise, corporate bonds—particularly high yield, and especially European high yield—are a bubble.

Credit spreads are tighter than they have ever been, just as global central banks attempt to coordinate a tightening of monetary policy. Central banks tend to become most hawkish right as the economy is about to roll over. Aggressive tightening now could cause a financial accident.

I think corporate credit is on the edge. If you have other corporate credit in your portfolio (including sovereign emerging market credit), I suggest you eject it now.

Indexing

Lastly, the indexing bubble is very important. And there is a commodity market precedent for what is going on with indexing in the stock market.

During 2006–2008, swaps on commodity indices were very popular. Commodities were seen as a new asset class, uncorrelated to everything else.

The problem was that commodities were lumped together as a singular “thing.” Yet, the fundamentals for corn and oil and copper are very different. But the fundamentals were ignored, all commodity prices rose together, and money kept plowing into the space. It didn’t make sense.

Investors believed that commodity investing had entered a new paradigm. You know what happened next. There was a global recession, flows into commodity index swaps reversed, and the price of oil and most other commodities crashed.

Everyone who thought commodity indexing was a new paradigm got carried out. I think the same thing will happen in equities. In a year or two, we’ll be taking a hard look at indexing. We’ll stop thinking of stock and bonds as an asset class, and return to thinking of individual stocks and bonds.

When equity index fund flows reverse—and they will—it will end very badly.

Get Ready

I hate being that guy who calls everything a bubble, but it's the truth. There are lots of things in the world whose prices cannot be sustained by economic fundamentals. And bubbles are often highly coordinated.

We have all the classic warning signs of a big market top:

• Extra-tight credit
• Extra-low volatility
• FAANG
• Complacency in general
• Retail looking smart, pros looking stupid
• Short rates rising, curve flattening
• Pain trade is probably lower, not higher

And yet people are mostly ignoring them.

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Grab Jared Dillian’s Exclusive Special Report, Investing in the Age of the Everything Bubble. As a Wall Street veteran and former Lehman Brothers head of ETF trading, Jared Dillian has traded through two bear markets. Now, he’s staking his reputation on a call that a downturn is coming. And soon. In this special report, you will learn how to properly position your portfolio for the coming bloodbath. Claim your FREE copy now.