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Kass: 10 Laws of Stock Market Bubbles

"Stock market bubbles don't grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception."

-- George Soros

The problem with bubbles is that if you sell stocks before the bubble bursts, you look foolish, but you also look foolish if you sell stocks after the bubble bursts.

Investment bubbles don't materialize out of thin air.

My friend (and recent Nobel Memorial Prize recipient in Economic Science), Yale professor Robert Shiller outlined how to identify bubbles in his seminal book, Irrational Exuberance (As you will read, there is some overlap in our identification process of bubble finding):

  • The sharp increase in the price of an asset or share class
  • Great public excitement about these price increases
  • An accompanying media frenzy
  • Growing interest in the class among the general public
  • 'New Era' theories justifying the high price
  • A decline in lending standards

Similar to Dr. Shiller, I have long felt that every bubble has distinguishable conditions leading up to them.

As I have consistently written over the years on Real Money Pro, bubbles typically emerge when these five conditions are all met:

  1. Debt is cheap.
  2. Debt is plentiful.
  3. There is the egregious use of debt.
  4. A new marginal (and sizeable) buyer of an asset class appears.
  5. After a sustained advance in an asset class's price, the prior four factors lead to new-era thinking that cycles have been eradicated/eliminated and that a long boom in values lies ahead.

Consider that all these conditions existed during dotcom stock bubble (1997 to early 2000):

  • Margin debt was inexpensive and readily available.
  • Daytrading shops and individual retail traders entered the market anew as the marginable buyer, lifting up share prices. The former (and some of the latter) was able to use 5x to 15x leverage.
  • Traditional ways of measuring value in technology, in general, and the Internet, in particular, were abandoned in favor of "pay-per-views, eyeballs" etc.
  • In turn, there developed the notion that technological innovation had likely repealed the economic/business cycles. (e.g. "The Long Boom").

These conditions also existed during the housing bubble (2000-2006):

  • The Fed lowered interest rates to generational lows. Correspondingly, mortgage loan rates plummeted to unheard levels.
  • Banks and shadow banking entities lent freely with interest-only and adjustable-rate mortgages commonplace. No-documented or low-documented loans became readily available. Loans in excess of 100% of home value proliferated based on the notion that home prices would never decline.
  • Individuals began to speculate in homes by virtually daytrading homes, as the new marginable buyer (speculators) lifted home prices to unprecedented yearly price gains.
  • The belief that home prices would never fall became the institutionalized and consensus view.

To my five conditions mentioned earlier, I add five more (several of these quantify the "degree of bubbliness" to complete my 10 laws of bubbles:

  1. Debt is cheap.
  2. Debt is plentiful.
  3. There is the egregious use of debt.
  4. A new marginal (and sizeable) buyer of an asset class appears.
  5. After a sustained advance in an asset class's price, the prior four factors lead to new-era thinking that cycles have been eradicated/eliminated and that a long boom in value lies ahead.
  6. The distance of valuations from earnings is directly proportional to the degree of bubbliness.
  7. The newer the valuation methodology in vogue the greater the degree of bubbliness.
  8. Bad valuation methodologies drive out good valuation methodologies.
  9. When everyone thinks central bankers, money managers, corporate managers, politicians or any other group are the smartest guys in the room, you are in a bubble.
  10. Rapid growth of a new financial product that is not understood. (e.g., derivatives, what Warren Buffett termed "financial weapons of mass destruction").

While some of the above conditions/laws have been met today, many have not.

While debt is cheap and plentiful to some, it is not universally so, as lending standards (especially mortgages and small-business loans) are relatively tight.

While investor sentiment is optimistic (and at multiyear highs), retail investors remain relatively noncommittal to stocks, and there is no new marginal buyer of equities (as was the case in the late 1990s). Nevertheless, the Investors Intelligence gauge of adviser sentiment (at a 55.2% bullish reading and only 15.6% bearish) is not only at the highest difference between the two in 2013 but at the most extreme reading since mid-April, a point in time when stocks experienced the largest correction of the current bull market that began in March 2009.

With over $50 billion of new-issue offerings thus far in 2013 (compared to $63.5 billion in the same period in 2000, the year the dotcom bubble burst) and follow-on offerings at a record $155 billion (year-to-date), conditions on this front are getting bubbly.

While some investors might be thinking that a new era lies ahead, they are in the minority.

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