The key to analyzing the bubble is to determine the cause of its occurrence, which increases your chances of making huge profits while avoiding significant losses.
Based on the data since the 1929 disaster, it should be concluded that the current “bubble” can lead to large sudden losses for investors.
Now the market is particularly susceptible to a sharp correction, notes American economist and lawyer Jim Rickards.
However, first of all, it is worth considering the very evidence of the existence of a "bubble". And the preferred measurement parameter is the CAPE coefficient, which was introduced by economist, Nobel laureate Robert Schiller of Yale University.
CAPE has several salient features that set it apart from the PE ratios used on Wall Street.
Firstly, it takes into account the company's profit on average over the past 10 years. This smooths out fluctuations caused by temporary psychological, geopolitical, and commodity-related factors that should not affect fundamental valuation.
The second feature is that this coefficient focuses solely on the analysis of past results. This eliminates the prospect of profit forecasts that Wall Street prefers.
The third feature is that relevant data are available up to 1870, which allows reliable historical comparisons.
Today, CAPE is at the same level as in 1929 before the catastrophe that led to the Great Depression.
Today, CAPE is higher than before the 2008 panic.
Moreover, none of the data points is the final proof of the existence of the bubble.
CAPE was much higher in 2000 when the dotcom bubble burst. None of the data points means that tomorrow the market will collapse.
But today, the CAPE ratio is 182% of the average ratio over the past 137 years.
Given reverse stock prices, this ratio makes storm warnings, even if we cannot know exactly where and when the hurricane will land.
Having determined the likelihood of a bubble, we can now proceed to analyze the dynamics of the development of the bubble.
The analysis begins by identifying two types of “bubbles”: narrative and credit “bubbles”.
The first type of “bubble” is based on a new paradigm that justifies the rejection of traditional indicators of assessment. One of the well-known examples of this type of “bubble” is the “bubble” of dotcoms of the late 1990s.
Investors raised stock prices excluding earnings, PE ratios, earnings, discounted cash flows or healthy balances.
In 2000, the dotcom “bubble” burst. NASDAQ fell from more than 5 thousand to about 2 thousand, and it took 16 years to regain lost ground and reach new highs.
The credit bubble has a different dynamics. If professional investors can borrow money at 3%, investing in stocks, earning 5%, and 3-in-1 leverage, they can earn 6% of the stock plus healthy capital gains, which can increase total income up to 10 % or higher.
Credit bubbles do not need a good story. They just need easy money.
The narrative “bubble” will burst as soon as the story changes.
Psychology and behavior change in an instant
When in 2000, investors realized that Pets.com would not be the next Amazon, but simply a novice with negative cash flow, stocks fell 98% in 9 months from the IPO to bankruptcy.
The credit bubble will burst when the credit runs out. The Fed will not raise interest rates simply to inflate the bubble: they are more likely to get rid of the riots after they try to guess when the bubble will appear.
But the Fed will raise rates for other reasons, including the Phillips illusory curve, which involves a trade-off between low unemployment and high inflation, currency wars, inflation, or going from zero due to the next recession.
Higher rates can lead to a break in the credit bubble.
Another main reason for the breakdown of credit "bubbles" is the increase in credit losses. Higher credit losses can occur with junk bonds (1989), emerging markets (1998), or commercial real estate (2008).
The collapse of credit in one sector leads to tightening credit conditions in all sectors, to recessions and adjustments in the stock market.
Now we are most likely observing precisely a credit “bubble”. Now there is no story like the history of the dotcoms. Investors look at traditional benchmarks, rather than their substitutes, found in Wall Street's corporate press releases and studies.
But even traditional estimates can turn around 180 degrees when the faucet that opens the flow of credit is turned off.
Milton Friedman once stated that monetary policy was acting late. The Fed pursued a zero-rate easy money policy from 2008 to 2015. and abnormally low rates after that.
And now the consequences have appeared. In addition to zero or low rates, the Fed has printed nearly $ 4 trillion in new money through its QE programs.
Inflation did not show up in consumer prices, but it did affect asset prices.
Stocks, bonds, commodities and real estate – all fly over the ocean of margin loans, student loans, car loans, credit cards, mortgages and their derivatives.
In March, the Fed decided to raise interest rates again under new chairman Jerome Powell.
In addition, the Fed conducts QE in the opposite direction, reducing its balance sheet and lowering the base money supply. This is called quantitative tightening, or QT.
Lending conditions are already beginning to affect the real economy.
Losses on student loans are growing rapidly, which hinders the formation of households and the geographical mobility of recent graduates.
Losses on car loans are also growing, which limit the sale of new cars. Along with these losses, the situation with mortgage loans and credit cards will also create pressure.
And soon you should wait for the recession.
The stock market is preparing for adjustment along with an increase in credit losses and tightening credit conditions.
No one knows for sure when this will happen, but now is the time to prepare. As soon as the market goes through adjustment, it will be too late to act.