You Don't Need A Bubble...

...to end a bull market.

Lots of talk of bubbles these days. In fact, I was interviewed on the subject just a few weeks ago. What seems to be left out of the chit chat about bubbles are the dynamics that go into bubbles (valuation model inputs) and the issue of how markets typically come to an end.

Granted, the popping of bubbles is one way to bear witness to the end of the current liquidity-driven global equity markets bull run. However, another, more likely (and more common) way would be a good, old fashioned garden variety market top. And, in that regard, there are few signs that the end of the party (replete with music and dancing and a punch bowl full of central bank liquidity) is at hand. For when the dominant players in the markets (investment professionals) are highly dependent on relative performance metrics (a/k/a alpha), trailing your peers is one of the best ways to lose clients (and your job, and your house in Greenwich). So, when one is flush with cash, dance and make merry is what you do - confident that one possesses the skills necessary to exit the dance hall just as the music ends and the central bank libations cease to flow.

Now, could such merriment lead to a bubble?

Bubble talk refers to the inputs that go into valuation models - earnings, growth rates, and interest rates - and their relation to price. History is used to reference prior periods when bubbles were formed and what followed when they burst. However, quantifiable as we want them to be, valuation models contain very highly subjective elements. They are tied to factors that reside in the social science worlds of the real and political economies and the financial economy. They are useful in the sense that they provide a zone of vulnerability where, in the past, bad things followed. They are, in many respects, like the psychology of investors in which rubber band-like qualities of investor sentiment can stretch beyond reason - and do so for far longer than one presumes*.

Bubble predictions are not, however, a statement of fact nor are they a justification for the need to explain how only an extraordinary event can disrupt the party underway. (Which is another way of saying "I, the investment professional, cannot possibly get it wrong on something so ordinary as a garden variety market top. It just has to be something unique - like a bubble!")

Investment Strategy Implications

Bubble talk is entertaining, interesting and somewhat informative. But understanding and appreciating the realities of a changed financial marketplace intersecting with the extraordinary economic, political, and monetary times we live in make for a more useful exercise. As for the signs of a market top, they just are not there. Divergences between markets exist but not to the degree that has in the past signaled the end of a trend. And the price and other momentum indicators are equally supportive of the existing trend in place.

That said, if one wishes to indulge in extraordinary items, perhaps a far more productive use of one's time might be the search for and understanding of how Black Swans form (the subject of my upcoming CFA Society San Francisco presentation next Thursday).

*"Markets can remain irrational longer than you can remain solvent."
John Maynard Keynes