NEW CONKERS3 FEATURE : The Analytical Surveyor
Analytical Surveyor has worked for over 40 years in the City and West End of London as a real estate investment manager, an equity analyst, a multi-manager, a fund manager and as a researcher and strategist. In his area of expertise, he is highly regarded and currently works as a consultant.
There is an enormous amount of academic research that provides insights into the functioning of investment markets. Rarely will this help with stock selection, but much of it will help in understand how and why the market functions the way it does. The Analytical Surveyor trawls through the work that is available in the public domain and summarises the work into useable notes for investors.
When will the bubble burst?
Bubbles are, of course, only bubbles when they burst; before that precipitous point, they are merely elevated markets. Government bond yields have, for instance, been trending down for most of the past twenty years and, at any time, investors might have withdrawn in fear that a reversal was almost inevitable.
If they had, they would have missed some of the asset class’s best performance over the last few years. Clearly, reaching new elevated pricing levels is not a sufficient basis on which to decide to exercise caution. Over the last few years, many economists and analysts have caution about the equity markets of the US (in particular) and Europe, which are at or close to all-time peaks but, more importantly, are at exceptionally-high cyclically-adjusted price-earnings ratios (CAPEs).
What we really need are some indicators that will help guide us in our macro investment decision-making. The recent research paper, Can We Use Volatility to Diagnose Financial Bubbles? Lessons from 40 historical bubbles by Didier Sornette , Peter Cauwels, Georgi Smilyanov 1 , is a useful analysis that might assist us in at least one indicator. Amongst the most recent bubbles examined, some of which may have passed us by without great acknowledgement, were the Oil bubble ending in July 2008, the Platinum bubble ending in May 2010, the Palladium bubble ending in May 2010, the Sugar bubble ending in November 2010, Gold bubble ending in September 2011, and the Swiss Franc bubble ending in July 2011.
The authors start with the general definition of an economic bubble as a period when financial assets are traded in high volume, and at prices significantly higher than the fundamental values. Their main finding is that, contrary to previous claims, there is no systematic evidence of increasing volatility as a diagnostic or an early warning signal that a bubble is present and/or developing. Sometimes volatility does tend to increase, often it decreases before the crash, and most of the time volatility barely changes as the bubble develops towards its end. Those investors who use the VIX as some form of leading indicator may, therefore, be using an unreliable measure – although low volatility does seem to precede a bubble collapse more often than high volatility.
Perhaps not surprisingly, one consistent indicator of bubble formation and development is credit expansion. It was not the authors’ intention to examine this as either a causal factor or an indicator of bubbles, but the dramatic rise in credit formation post the 2008/9 global recession provides a powerful backdrop for the formation of multiple bubbles. It will be interesting to see what significance there is in the recent negative movement in the global credit impulse 2 . The credit impulse is a measure of the acceleration (ie second-order derivative) of credit. According to UBS, in the US, the correlation between activity and the impulse is very strong and the current fall matches the magnitude of the impulse plunge in the immediate aftermath of the financial crisis.
1 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3006642
2 http://www.zerohedge.com/news/2017-06-12/ubs-has-some-very-bad-news-global-economy http://www.zerohedge.com/news/2017-06-20/why-collapsing-global-credit-impulse-all-matters-citi-explains
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