Are the Linked In/Groupon IPOs proof we have a new bubble in Tech? Are US Treasuries a bubble? Commodities?

There have been numerous attempts by many Fed economists to argue that bubbles cannot be seen as they happen, and they we can only spot them after the fact.

I believe they are incorrect. We can spot bubbles as they happen, so long as we rely on a variety of data points.

Consider these 10 elements a checklist to identifying bubbles in real time:

1. Standard Deviations of Valuation: Look at traditional metrics –  valuations, P/E, price to sales, etc. — to rise two or even three standard deviations away from the historical mean.

2. Significantly elevated returns:  The S&P500 returns in the 1990s were far beyond what one could reasonably expect on a sustainable basis. The years around Greenspan’s “Irrational Exuberance” speech suggest that a bubble was forming:

1995    37.58
1996    22.96
1997    33.36
1998    28.58
1999    21.04

And the Nasdaq numbers were even better.

3. Excess leverage: Every great financial bubble has at its root easy money and rampant speculation. Find the leverage, and speculation won’t be too far behind.

4. New financial products: This is not a sufficient condition for bubble, but it does seems that each major bubble has new products somewhere in the mix. It may be Index funds, derivatives, tulips, 2/28 Arms.

5. Expansion of Credit:  This is beyond mere speculative leverage. With lots of money floating around, we eventually get around to funding the public to help inflate the bubble. From Credit cards to HELOCs, the 20th century was when the public was invited to leverage up.

6. Trading Volumes Spike: We saw it in equities, we saw it in derivatives, and we’ve seen it in houses: The transaction volumes in every major boom and bust, almost by definition, rises dramatically.

7. Perverse Incentives: Where you have unaligned incentives between corporate employees and shareholders, you get perverse results — like 300 mortgage companies blowing themselves up.

8. Tortured rationalizations: Look for absurd explanations for the new paradigm: Price to Clicks ratio, aggregating eyeballs, Dow 36,000.

9. Unintended Consequences: All legislation has unexpected and unwanted side effects. What recent (or not so recent) laws may have created an unexpected and bizarre result?

10. Employment trends:  A big increase in a given field — real estate brokers, day traders, etc. — may be a clue as to a developing bubble.

11. Credit Spreads: Look for a very low spread between legitimately AAA bonds and higher yielding junk can be indicative of fixed income risk appetites running too hot.

12. Credit Standards: Low and falling lending standards are always a forward indicator of credit trouble ahead. This can be part of a bubble psychology.

13. Default Rates: Very low default rates on corporate and high yield bonds can indicates the ease with which even poorly run companies can refinance. This suggests excess liquidity, and creates false sense of security.

14. Unusually Low Volatility: Low equity volatility readings over an extended period indicates equity investor complacency.

The Fed has previously suggested that spotting bubbles in real time a black art; I believe that it can be more science than art, so long as we quantify the various data points and consider them objectively.

~~~

Note: This was adapted from material previously published on TBP on October 22nd, 2008 and December 2nd, 2009.

Category: Contrary Indicators, Psychology, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

21 Responses to “Checklist: How to Spot a Bubble in Real Time”

  1. dss says:

    I think that they also know the signs of a bubble forming, but they choose not to address it. Who wants to be the spoilsport at a party? Let the free markets work their magic! And if they need a job in the private sector after leaving the Fed, it would be bad form to try to interfere with a bubble.

  2. crutcher says:

    It drives me nuts, BR… you have all the qualities that would make for an ideal regulator, prosecutor, or policy wonk, yet you abandoned law to manage money… look I realize that the system is not rigged in favor of the best people for the job actually getting these jobs, quite the opposite at times. But doesn’t it strike you as odd, frustrating, or even maddening that it’s you if anyone who has to teach these people how to do their jobs?

    The Republican ticket’s very much in the air buddy! I exaggerate of course… but still, you see the point, no?

  3. JimRino says:

    Sheesh, I hope Barry Doesn’t Become an Republican.
    They are wrong 90% of the time, the last 10% is Luck.

  4. Ted Kavadas says:

    Good post; especially timely as I believe that there are many asset bubbles currently in existence, both here (U.S.) as well as globally.

    There are a few items that I think could be added to the list…one would be the existence of Moral Hazard, which is particularly relevant to our current situation.

  5. lalaland says:

    #15: “This time it’s different” – the sweetest of the siren songs

  6. “The Fed has previously suggested that spotting bubbles in real time a black art…”

    BR,

    really, What do you expect them to say?

    Where, ultimately, do you think this.. 3. Excess leverage: Every great financial bubble has at its root easy money and rampant speculation. Find the leverage, and speculation won’t be too far behind.

    is coming from?

    maybe, http://search.yippy.com/search?input-form=clusty-simple&v%3Asources=webplus&v%3Aproject=clusty&query=Federal+Reserve+Lender+of+Last+Resort ?

    and, now, that they’ve bloated their own ‘Balance Sheet’, their looking to prop up, and pump up, the IMF to further the obsfuscation, and keep ‘the Game’ going..

    better, We should know http://search.yippy.com/search?input-form=clusty-simple&v%3Asources=webplus&v%3Aproject=clusty&query=Federal+Reserve+Fraud

    http://search.yippy.com/search?input-form=clusty-simple&v%3Asources=webplus&v%3Aproject=clusty&query=%E2%80%9CFrom+now+on%2C+depressions+will+be+scientifically+created.%E2%80%9D+%E2%80%94Congressman+Charles+A.+Lindbergh+Sr.%2C+1913+

    But, hey, when ‘the Grift’ pays, be a “Grifter”, yes?

    http://www.thefreedictionary.com/grift

  7. AHodge says:

    a beautyful list
    what i am working on,
    its not even another point yet
    is asset values beyond the capacity of the world economy to support them with cashflows, even eventual.
    we know this so for things like tech stocks
    but even debt may not have reliable cashflows to support it
    the US net debt is said to be 360% of GDP

    Also the global cashflow will not rise huge in trend
    and it will inevitably be somewhat unreliable cyclically,
    may not be enough even in mild downcycle to service the debt much less equity

    so even without cashflow data, when asset values double or more, one might be deeply suspicious

  8. bulfinch says:

    RE # 10: FWIW There’s a buttload more landlords running around these days than I ever recall their before being. Five or ten years ago, I didn’t know anyone who was a landlord, let alone salivated over buying up as many SFHs (in cash or through multiple mortgages) as rental properties; today, however, I know three landlords personally and read about/overhear an increasing number of people jumping on this particular bandwagon.

  9. jaymaster says:

    “Irrational exuberance” is just highfalutin academic speak for “bubble” , so for Greenspan to claim they couldn’t see it happening is bogus.

  10. mgblog says:

    There are two problems with this list:

    1. There are many points that require too much divination (4,7,8,9,10,12) or become clear only with hindsight.

    2. If a bubble is diagnosed, it’s difficult to act on that conclusion. Arguably there was a credit bubble in the US since 2005, but the roof only truly caved in during the third quarter of 2008. Sitting on the sidelines for 3 or so years would have been very painful, if not unsustainable for money managers. The trick is not just to identify the bubble, but to know when it will pop. If things were that easy then one could ride the way up, sell at the peak, pause, buy at the trough when the collapse comes and become fantastically wealth. Unfortunately things are not that easy.

  11. kevin r says:

    Back in April as Silver was touching it highs it seemed like every comment section of every article either pro or con on the poor man’s gold was an excuse to rationalize why silver was only going up. The exuberance in the comment sections was undeniable and a good indication the balloon was inflating.

    My favorite “Tortured Rationalization” was that a US built cruise missile takes 32 lbs. of silver to make and then destroys it all. This was going to drive Supply down, and the price up!

    Aside from having doubts that the commenter knew how much silver is in a cruise missile, the math still seemed like a stretch. First, cruise missiles are not used very often, mostly as an opening salvo to soften up the area for fighter jets. Second, while 32 lbs. seems like a lot of silver for an individual to waste, it is not really very much. There is something like 20,000,000 lbs. sitting in the iShares Trust (if you believe them). And BTW, that SLV silver supply is not getting destroyed, although its value kind of did in May.

  12. [...] to spot a bubble in real time.  (Big Picture, All About [...]

  13. Sunny129 says:

    If one plots the result of those ‘data’ ona chart with cross currents ‘for and against’ and the ability to discern the ‘net effect’ on the market is one factor and to have a FIRM conviction like Buffett to ‘act’ on that is another factor.

    This is well demonstrated on the study of various ‘investing’ letters vs actual performance their own portfolio indicating ‘ they don’t follow their own advice’ means their ‘conviction’ factor is very weak!

    To me it is more than a Science and an Art but also wisdom, experience and guts to act on your conviction!

    WISDOM is ability to act on the ‘correct’ side before ALL the FACTS are IN! – Warren Buffett

  14. Sigi says:

    This is an interesting summary, but lacking the background of some of the items you have mentioned, it would be helpful if some links to articles explaining some of the concepts were provided.

    E.g. “Dow 36,000″, “HELOCs”, etc.

    Can you maybe update the article with some links? I understand that it would require some work, but help the noobs among us tremendously.

  15. dsawy says:

    Add to #8: “it’s a New Economy…”

    Unless talk of “new economy” is supported by evidence that the new economy somehow lives on a different planet than the current economy, you’re probably listening to the most tortured of rationalizations.

    #3: I believe that this should be #1. Bubbles cannot happen without credit to fuel them. When/if bankers and “financial professionals” have to put only the money they have in front of them on the line, they tend to be less speculative.

  16. cognos says:

    So…

    1. Currently there is ZERO “standard deviation” excess in stock valuation. I show SPX at 14.68x… materially below its historical mean (and into eps growth, and again ultra-low financing).

    2. Currently there is ZERO “excess leverage”. In fact, borrowing is seriously constrained by many factors eminating from the 08 crisis.

    Ergo… pretty much ZERO bubble action. Buy the dip. Its a recovery.

  17. cognos says:

    Also,

    Please note that the “Internet” bubble appear quite logical in an attempt by the public to capture valuations that we now see in those companies — GOOG $200B, AAPL $330B, Facebook $100B, AMZN $90B, etc.

    There is plenty of risk/reward in investing. The spec bubble and bust is an natural as life itself. What? You think everyone should just make a steady 5-10% annually? (Then I’ll lever that 10x… cause a bubble, make 10-20% x 10 for 5 years… and then sell it to the follow-on sheep).

    Life is full of ups and downs. Try to enjoy them.

  18. [...] Must-read: how to spot a bubble in real [...]

  19. doodad says:

    I find a much lower-tech method just as reliable:
    - If someone’s making *way* too much money, seemingly with no effort, it’s a scam
    - If the scam is open to lots of people to pile in, it’s a bubble (or Amway)

  20. [...] Barry's Bubble Checklist should be printed out and hung in your office.  (TBP) [...]

  21. carpediem0496 says:

    BR,

    This is a very good list. It is the confluence or correlation of these elements that will both determine the existence of a bubble and the magnitude of a bubble. Of course, this will make one’s conclusion both art and science (i.e. math).

    I suggest that the following would also be helpful.

    Fed policy needs to be evaluated even though it is linked to an expansion of credit. If there was ever a illustration of the short-term power of the Fed, it the results equities and bonds have shown over the past couple of years with QE 1 and 2.

    Market capitalization is also an indicator. When compounding and the law of large numbers are ignored or explained away, it can indicate extraordinary times.