Bubbles: What are they and why does everybody get so “excited” about them?

So, what is a Bubble?

A bubble is a rapid, unjustified acceleration in the price of something. The price uptick is typically driven by excitement or implausible assumptions about the asset’s future. When investors pay prices exceeding an asset’s true intrinsic value, a bubble forms.

Capital investments (when I say capital, I mean cash) feed the bubble at the expense or neglect of other assets and sectors. Eventually, the bubble must burst. Inflated prices are corrected, and investors again pay attention to the neglected sectors.

Simply put, a bubble is a misallocation of capital (cash).

Take the internet bubble that burst in 1999. For several years prior, investors bought into technology stocks at levels some called a “frenzy.” Investments far exceeded the actual value of the internet technologies and flooded the sector with unnecessary capital (cash). Meanwhile, forgotten sectors like industrials and materials suffered from low investment levels. After the bubble burst and prices corrected, technology was the worst-performing sector of the next decade.

You and I can use our economic good sense to detect bubbles as they form, but we cannot know how long a bubble will last or whether it is beginning or nearing the end. Such wisdom requires a window into the future that none of us has.

What is causing today’s Bubbles?

Today’s bubbles are in the financial markets, particularly bonds. While markets have historically determined interest rates, both political parties have kept interest rates extremely low for the last decade to stave off corrections or economic slowdowns. It’s a lot like driving in Missouri — there is no yield.

This form of interest rate manipulation not only distorts the prices of things but also leads to other problematic practices. For example, a corporate borrower paying 3% interest instead of 10% can engage in poor financial management practices for longer, avoiding potential bankruptcy for a decade or more.

Compared to the internet bubble of 1999, today’s circumstances may be more extreme. Capital has flowed into riskier and riskier assets. (Ecuadorian Railroad bonds, anyone?) Investors today are hyped about artificial intelligence (AI), autonomous vehicles, and other technologies envisioned to shake up the future. Meanwhile, core industries and materials, even oil and gas, housing, commodities, and metals like gold and silver are starved for capital after ten years of underinvestment (long before COVID-19).

For the first time in modern history, companies like Chevron and Exxon are not investing enough to even replace their reserves. Prolonged underinvestment has caused the production bottlenecks and undersupply of certain goods that we are experiencing today.

Inevitably, this underinvestment will lead to higher and higher prices in the starved sectors. Today’s shortages and supply chain issues may take much longer to play out than most expect. Eventually, this bubble too will burst. Only the strongest of the overhyped sectors will survive, and investments will flow again into the neglected sectors.

What should I do during a Bubble?

Knowingly or not, you may already be participating in or enabling the bubble – for example, by owning a corporate bond fund or a high yield fund. On the other hand, some investors take extreme steps to avoid a bubble or to sidestep it, thinking, “I’ll just sell out and spend my time on the sidelines.”

But, I offer this one piece of advice that holds for any bubble situation:

Invest in sectors or ideas where capital is scarce.

Most who invest in a price-inflated asset during a bubble will miss out on any potential gains from their investment. Instead, you’re better off remembering that, during a bubble, money is spent on one asset or sector at the detriment of allocating it elsewhere.

It is the “elsewhere” that excites CSH Investment Management LLC. Real opportunities exist today if you don’t follow the frenzy.

We have a plan for when the bubble eventually bursts. Let’s work together to build a portfolio that protects your capital from permanent loss. We can help you see the opportunities a bubble presents for today as well as the future.

Give us a call at 217-824-4211 if you have questions about how your portfolio is being managed, or if you’re uncertain that your current advisor is proactively managing the current bubble with an eye toward the future for when it finally bursts. We’re always happy to chat with you!