Asset bubbles are hard to spot. They tend to sneak up on us, growing slowly into something unsustainable. Then they hang around for much longer than the typical sceptic would predict, making them seem normal. Then, all of a sudden, they pop, taking most people by surprise.
Only in retrospect are they obvious to everyone. However, that doesn't mean that they were impossible to see. It just means that most people ignore the warning signs, preferring instead to ride the tide in the hope of quick profits or in fear of missing out. There's a great deal of wilful ignorance in all of us, and that's the main reason that so many of us get ourselves into financial trouble. But bubbles are relatively easy to spot when we're willing to look.
My preferred method for spotting an asset bubble is long term charts of price action relative to gold or earnings. I find such charts revealing. They make it immediately clear where we are relative to historic peaks and troughs. However, they don't tell us why a certain price range can be considered overvalued while another price range can be considered undervalued. Why is a bubble a bubble, and why is it never different this time? Why can't prices stay permanently overvalued?
To answer these questions, we need to look into the fundamentals of our existence, that we must consume in order to live, and that most of us cannot or will not be productive our entire lives. There is a period in our lives when we consume without producing anything, and the only ways we can do this is through some form of capital income, or by selling something that we bought earlier.
Also of importance is the value we attach to our time and labour. We don't generally accept that a life of hard work and prudent living should return nothing but a meagre allowance. We should be able to sustain a reasonable level of consumption through our unproductive years, and there should ideally be something left for the next generation in way of an inheritance. To attain this type of comfort, we're prepared to put aside somewhere between 5% and 20% of our after tax income over a maximum period of 45 years of labour.
With this in mind, we can take a closer look at the three main asset classes of stocks, real-estate and gold.
The simplest of these is gold. It's a metal. It generates no income. Its only financial virtue is that it requires no maintenance, and it can be stored for free. All things being equal, gold retains its value over time. It's purchasing power goes neither up nor down. It can therefore be used as a measure of value relative to real-estate and stocks. Gold is what we save in when both real-estate and stocks look expensive. Otherwise, it's not a good investment. Someone putting aside 5% of their income in gold will have to save 20 years to achieve 1 year of retirement. Putting aside 20% achieves only 1 year of retirement for every 5 years of savings. 45 years of work results in only 2 to 9 years of retirement.
Things get a little more complicated when we consider real-estate. If neither lived in nor rented out, real-estate is like gold, only with the added problem of fixed costs. There are taxes, fees, service charges, and maintenance costs. Owning a piece of real-estate can be expensive, so it has to be lived in or rented out to make sense as a long term investment object.
A simple way to judge the general price level of real-estate is to compare the cost of rent to that of ownership. If the full cost of owning a house with a 100% mortgage comes out about equal to that of renting a similar property, we can say that the price is fair, provided interest rates are at their historic average of about 6%. If interest rates are lower, the cost of the loan may be deceptively low. If the interest is above the historic average, the opposite may be true. It all depends on the rate of inflation, and hence the real inflation adjusted interest rate.
A more straight forward way to judge the cost of buying a house is to calculate the number of years it will take to pay it down, assuming no change in salary and no inflation. A modest house should take no more than 15 years of our lives to pay down at a maximum savings rate. Otherwise, there's not enough time to amass savings for day to day expenses during our retirement. We'll be forced to sell our house, and the rent over the next 15 years is likely to consume the entire surplus, leaving nothing for day to day expenses.
The reason we should assume no change to our income is that we could, if we so chose, buy gold for an equivalent amount. If house prices are relatively high, gold is likely to outperform real-estate due to the above mentioned selling pressure. That makes gold a better investment than the more complicated and costly alternative that is real-estate.
The great virtue of stocks, as well as the only long term reason for owning them, is their future earnings. They represent working capital from which we can derive capital income. Ideally, we should be able to amass enough working capital during our careers to provide capital income equal to our living expenses. Otherwise, we'll be forced to sell some of our stocks during our retirement. We may even have to sell all of it, in which case we run the risk of not being able to pay our bills at the very end of our lives.
This explains why stocks priced above 15 times their earnings are to be considered expensive. There have to be some very promising future returns on the horizon to justify such prices. The reason for this is that we'll be unable to amass sufficient capital at such prices to support our future expenses. The situation becomes similar to that of gold, with the only difference being a modest earnings stream during our years of capital accumulation. While it's true that compound interest can add up to quite a lot, even at low rates, we're not going to be wildly more successful saving in stocks at prices above 15 times earnings than we would be if we saved in gold instead. But for simplicity, let's say that we manage to get a return twice as much as gold. Our 45 years of work would then result in savings equivalent to 4 to 18 years of work. That would require yields from 5% to 20% in order to cover our living expenses, only barely inside the 6.5% implied in a price/earning rate of 15.
This means that stocks priced at P/E ratios above 15 will see selling pressure some time in the future. It must happen, because most people don't put aside the required 20% of their earnings for their retirement. Only a fantastic increase in productivity can save us from having to sell stocks during our retirement years. With the S&P 500 currently registering a P/E ratio of about 40, we can safely say that stocks are not the place to be invested at the moment.
From the above analysis, it would appear that there are no good investments at the moment. Gold has no earnings. Houses take longer than 15 years to pay down, and stocks are priced way above 15 P/E. However, this misses the most important point about gold, namely its function as money. Gold is where we hide out while real-estate and stocks are overvalued. Gold is where we lock in profits. It's where we avoid taking future losses. The reason we cannot use cash for this purpose is that cash is debased by central bankers over time. It doesn't keep its purchasing power nearly as well as gold over long time periods. Cash can even go to zero, as happened in Weimar Germany.
On a similar note, we know that Bitcoin isn't money either. There are fixed costs associated with Bitcoin that makes it similar to unutilized real-estate. The fact that it has no utility beyond being a lottery ticket makes it a very precarious investment. There's constant selling pressure in Bitcoin. With no corresponding real world demand, it's doomed to eventual failure.
This doesn't mean that gold cannot be in a bubble. Gold is in a bubble when both real-estate and stocks are relatively cheap. Hiding out in gold is a terrible idea when there's plenty of opportunities in other assets. However, it's a great idea when there's hardly any opportunities to be found. As things stand at the moment, there's a bubble in real-estate and a bubble in stocks, which brings us to our final questions. Why do bubbles tend to pop rather than deflate in an orderly fashion, and why is it so difficult to time the exact moment when this is about to happen?
The short answer to these two questions can be summed up in two words: forced selling. There is for every bubble a point in time when people will have to sell in order to cover their expenses. However, there's no telling exactly when this happens. But when it happens, there's a cascading effect that forces others to sell. The first ones to sell are generally the most underfunded and exposed investors. Faced with immediate expenses, and unable to cover this through credit, they have no option but to sell.
This pushes the price of the inflated asset down, making it harder for the better positioned to cover their expenses. They must either take on more credit, or sell. If they choose the latter, prices go down further, exposing another layer of investors who in turn are faced with the same predicament. Suddenly, everyone panics, and the bubble implodes.
A key factor in this is credit. Cheap credit can push the day of reckoning into the future. It can also elevate a bubble to higher highs. The S&P 500 is a good example of this. Its P/E ratio hasn't been below 14 since 1990. It hasn't been below 10 since the mid 1980s. My generation of investors haven't seen cheap stock prices since we were in our early 20s, and I'm 57. So what happens when my generation goes into retirement? Pretty much all of us are underfunded. Will we be able to borrow our way through our retirement years? I doubt it, so a correction is likely going to come relatively soon. It may not be here tomorrow, but it's hard to see how this can go on for another decade without the whole thing imploding.
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| Reflection in a soap bubble |
By Brocken Inaglory. The image was edited by user:Alvesgaspar - Own work, CC BY-SA 3.0, Link
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