Bubbles are fun when you are 5, less so when you are 50. Where are we now?
Economist, Silvio Contessi wrote a thoughtful article for The Regional Economist, a quarterly publication of the Federal Reserve Bank of St Louis. It is on page 4 and following. The PDF is here
The point deals with asset bubbles and the discussion is worth noticing. It is easily possible that the stock market is in bubble territory.
Asset bubbles are well known after the fact and they are easy to find in history. How could the people of the time been so thick?
Maybe it is more subtle than that.
Suppose it is possible to have a liability bubble. Essentially a liability that has a value. It cannot be expressed that way exactly, so the value of the strange liability will attach to something else.
- Suppose someone buys a $500,000 asset and finances $400,000 of the purchase price at market rates.
- Suppose that money has a real annual value of 2%, plus average expectation of inflation over the period committed, plus costs, plus taxes. An investor wishing passive, safe returns might be willing to accept that. Today that could well be a 6% nominal rate.
- Suppose that the fixed investment period is 10 years and there are level monthly payments that will liquidate the debt over that time.
- Suppose further that the nominal rate is 3%.
In our 3% world the monthly payment is $3,859.
In a 6% world, $3,859 monthly will finance a bit less than $350,000.
The monthly payment and the term are the same. The rate alone creates a different beginning balance. That difference is the value of the financing. In this case $50,000. That difference would double if the term was 25 years instead.
The meaning works like this. The asset is worth $500,000 as agreed. It is composed of two parts, being its real value of $450,000 plus the $50,000 value from cheap financing.
If the asset value drops when rates go up and the financing gain goes away, would that be because we had experienced an asset bubble?
It will look that way, but it is easier to understand if you think about it as the real asset value never changed and the liability bubble went away.
This analysis applies most easily to housing but the idea can fit any situation. Cheap money increases demand. Some stocks are worth the price because people can borrow cheap. Sometimes dividends covers the interest. A free ride.
We are in challenging times. They will be harder to understand and cope with if we miss where the bubble really lives.
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Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.