Threat of rising inflation could burst any number of asset bubbles

Identifying an asset bubble is not easy. They are only obvious after the bubble has burst – time alone gives definition. Americans may soon get another lesson in asset bubbles. The threat of rising inflation could burst any number of them.

One working definition of a bubble is when an asset’s market price far exceeds its fundamental value and is not justified by estimated price earnings. Artificially high asset valuations that are based on misconceptions that distort reality.

There is certainly disagreement about what is the correct measure of price earnings and one can only estimate fundamental value. Even if the diagnosis is correct, you don’t know when the bubble will burst.

Put simply, bubbles are booms that went bust, followed by a crash – a rapid decline in market prices. After all, that is what bubbles are supposed to do.

Bubbles make for interesting stories. Charles MacKay’s classic book, “Memoires of Extraordinary Popular Delusions and the Madness of Crowds,” was first published in 1852 and is still in print. Fabled asset bubbles are the Dutch tulip bubble of the 1630s, the South Sea and Mississippi bubbles of 1720, the run-up in American stock prices in the 1920s, the dot-com bubble of the late 1990s, and the housing bubble of the mid-2000s, when U.S. housing prices were 50 percent above their long-term trend.

Today there may be asset bubbles in specific markets, such as housing, cryptocurrencies, and stocks. U.S. housing prices rose more than 10 percent last year. The housing market is booming for one key reason: low interest rates. Prices for cryptocurrencies, an asset that doesn’t produce cash flows, rose more than 500 percent in the last year. This surge in the price of unregulated cryptocurrencies such as Bitcoin and Dogecoin has attracted the attention of many investors.

Then there is the incredible explosion in Special Purpose Acquisition Companies (SPACs). This is a company that is formed strictly to raise capital through an initial public offering for the purpose of acquiring an existing company. Also, known as “blank check companies,” SPACs have been around for decades. But new issuance of SPACs has skyrocketed over the past year. Over $75 billion was issued in 2020. Less than three months into this year, they have raised more than $78 billion.

The U.S. stock market ended 2020, another year that will live in infamy, at record highs. After bottoming out during the initial COVID-19 lockdown in March, the S&P 500 rose 68 percent in 2020, finishing the year up more than 16 percent, shattering all-time records along the way. The Dow Jones Industrial Average and the tech-heavy Nasdaq gained 7.25 percent and 43.6 percent respectively, despite the public health and economic crises.

One condition that typically accompanies asset bubbles is easy credit that turbocharges speculation and benefits borrowers.

Federal Reserve Chairman Jerome Powell is continuing the massive expansion of money and credit. Americans hope these policies don’t make a monkey out of Darwin.

Powell recently said the Fed won’t raise rates until they see a 3.5 percent unemployment rate and inflation averaging better than 2 percent. Inflation in not high on the Fed’s list of worries. Their top concern is mending the labor market. Both the Fed and the Biden administration are focused on getting the 10 million unemployed back on payrolls.

The bond market appears skeptical about letting inflation rise as 10-year bond rates are increasing – a signal from investors that they expect higher inflation. The bond market is apparently concerned that inflation would cut into buying power and force the Fed into rate hikes that could pop some of these asset bubbles that inflated thanks to rock-bottom interest rates, creating big risks to the economy.

To strike an optimistic note, if faintly, the accelerating rollout of COVID-19 vaccines has set the stage for rapid economic recovery in the second half of this year, hopefully with limited inflation. So, place you bets accordingly.

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