Previous economic crises were caused by the bursting of speculative bubbles: a technology bubble in 2001 and a real estate bubble in 2009. To position themselves in advance when they think they have identified a strong trend, speculators tend to push the price of the assets concerned using derivatives until the price reaches levels that far exceed the real value of these assets. Which sectors are most likely to form a bubble?
Many people think bubbles are still being created in the market, in certain commodities, for example, and even in U.S. Treasury bonds. These assets have increased in price over the past year and are already priced much higher than their long-term average. Why is speculative fever returning? One reason is the same one that fuelled the two previous bubbles: incredibly low interest rates that flood commercial banks with cheap money, providing them with a huge pool of funds with which to grant loans. Investors use money borrowed at a very low rate to acquire assets and artificially increase demand for these assets, inflating prices to unsustainable levels. Others think that although interest rates are extremely low, commercial banks are still not lending and demand for loans is still weak, leading them to believe that it is still too early to worry about a bubble.
How can we identify a potential bubble? One way is to compare the price of an asset with its long-term historical average. For commodities, we look at the inflation-adjusted price; for bonds and for the stock market, we examine the income-price ratio.
For bonds, the benchmark is generally the 10-year U.S. Treasury bond. Presently, the return on these bonds is around 3.6%, which is well below the average posted between 1993 and 2007. During that period, 10-year U.S. Treasury bonds produced an average return of 5.5%, while the average inflation rate was 3%. Adjusting for inflation, these securities actually generated a return of 2.5%. If we assume that the average inflation rate is still 3%, the return on this type of bond is now only 0.6%. So when the Fed decides the time has come to fight inflation and raises its key rate, the rate on 10-year bonds will surely rise to 5.5%, resulting in significant losses for investors who hold them. Bond prices move in the opposite direction to their yield; consequently, when interest rates rise, bond prices fall. It is a purely mathematical reaction.
Another risky asset is oil. Presently, we might think that at $80 a barrel, the price of oil is a bargain, compared with the price of $147 a barrel in July 2008. It costs between $55 and $60 to produce one barrel of oil. Historically, commodities have, over long periods of time, never traded at a price higher than what it costs to produce one unit. At $80, there is no question of a bubble of the same magnitude as the one in 2008, but the forces of gravity are working to bring the price closer to its long-term unit cost. Oil producers are posting profit margins on the order of 30% to 40%. These margins will have the effect of increasing production and lowering prices.
Gold is another risky asset. Investors seem to be eternally attracted to the yellow metal, which they use as a hedge against inflation – which everyone is expecting soon – and against a decline in the U.S. dollar. The price of gold has been climbing steadily since 2009. It has risen from $875 to $1,100, i.e. three times the average price between 1990 and 2004. The price of gold is so high that people are selling their jewellery, which is then melted down. The same thing happened with silver in the 1980s. The price of silver then tumbled from $50 to $15, and the same thing could happen with gold.
The stock market is the last category at risk of forming a bubble. Suppose investors expect a return of 10% from stocks and the S&P 500 is the only business that offers investors a return composed of both dividends and capital gains. Together, the market and the S&P 500 should produce a return of 10%. Presently, the dividend return is about 2%, which means earnings must grow by 8%. We know that earnings growth is closely tied to GDP growth, which is far below 8%. In fact, it’s around 3%, which suggests that the stock market may already be overpriced.
Will we see bubbles in these four sectors? It’s possible. The future will tell. However, we do know that prices have always returned to the norm.