The Fed turns a blind eye to yet another asset bubble…

3 mins. to read
I’m forever blowing bubbles, pretty bubbles in the air…

Despite the recent comments made by the Bank of International Settlements in its annual report urging for the Western world’s central banks to reverse the course of super loose monetary policy in developed countries and to allow for increases in interest rates (as the bank sees investors ignoring risks and thus an asset bubble forming), it seems that these comments have fallen on deaf ears at the Fed and the BoJ who both prefer to pretend everything is hunky dory and that asset prices are in line with intrinsic values…

The Fed recognises that equity prices have been rising and that they are currently near all-time highs, but has this week attempted to justify them as being based largely on sound valuations. As stated in its latest monetary policy report sent to Washington on 15th July (

Some broad equity price indexes have increased to all-time highs in nominal terms since the end of 2013. However, valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities (p.20)” 

But investors should be very careful of such rhetoric because although the Fed believes the broader market is at normal levels by historical standards (i.e. forward price-earnings multiples), the bank thinks differently regarding specific sectors:

“Nevertheless, valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year. (p. 20)” 

So, some small companies in biotech and social media may already be far from earth, like the dot-coms during the 1990s. Tell us something we don’t know!

The FED also adds a very important observation:

Issuance of speculative-grade corporate bonds and leveraged loans has been very robust, and underwriting standards have loosened (p.22).”

Summing it all up, the Fed, surprise surprise doesn’t see any wide bubble in the market, but understands that risk taking is still “on” as investors are seeking higher yields in riskier assets. We think that the Fed’s view falls far short of reality. Take a look at the 2 charts below.

When investors become too optimistic they throw additional money at the market. The more entrenched the bullish sentiment, the more aggressive investors become. Sentiment in fact distorts risk perceptions.

Investors, at heart, just want to maximise gains and in the late stages of a bull market discount the downside risks. They direct their money towards the companies that offer the supposed better return opportunities, which are most likely those that are more difficult to value due to a lack of historical data, positive earnings history and dividend payments. These companies also tend to be small, with less analyst coverage, greater volatility and very optimistic growth predictions. Biotech and social media are some examples that fit very well inside this group, but any others related to new technologies are good candidates. High demand for these equities result in a massive price rises, and so become out of kilter with the risk inherent. When this demand is stretched over a long period of time, the disconnection between price and value gets stretched and likely pushes other equities higher too. At some point, the whole market gets removed from its fundamentals. The name for such situation is an asset bubble.

While the Fed doesn’t recognise the later stages of an asset bubble in its report (why should they too, they have after all missed the last 3?!), they at least accept we are witnessing excessive levels of exuberance in certain areas of the marketplace. Those comments should be taken as a sign that the rally is now approaching unsafe levels. It is now time, in our humble opinion, to hedge any bullish bets even if at the cost of losing some upside potential in the near term. 

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