We are now facing four economic bubbles, and we are in uncharted, unprecedented territory.
1. Stock Market Bubble
The first bubble has to do with the overvaluation of the stock market. According to the Schiller PE (price-to-earnings) Ratio, which takes the price of the S&P 500 and divides it by the average of ten years’ worth of earnings, as of October 8, 2018, the ratio was over 33.
There have only been three times when we’ve been at levels this high where stocks were overvalued this much: 1929, 1999, and 2007. Everyone knows what happened in 1930, when the Great Depression struck, and in 2008, when the real estate mortgage bubble burst, sending us spinning into a global recession. Less well-remembered is the 2000 tech stock bubble bust, which sent the NASDAQ plummeting by 70% and the S&P down by 50%.
What will happen to the stock market by 2019 or 2020? No one knows for sure, but most experts are predicting the worst.
Stock prices usually increase when there are lower interest rates or higher earnings. Interest rates are going up, not down, and looking ahead to 2019, we’ll most likely see lower corporate earnings, so that’s two strikes against a continuing bull market. This year’s corporate tax cut windfall (especially the one-time tax repatriation for international firms) was primarily used by corporations to buy back shares, which helped increase their earnings. It’s going to be very difficult for 2019 corporate earnings to beat 2018’s, so expect the market to be trading lower.
2. Real Estate Bubble
Interest rates, while slowly being raised, are still artificially low due to the Federal Reserve’s quantitative easing policies enacted after the 2008 real estate bubble burst. This is keeping mortgage lending rates appealing to many home buyers, although demand is starting to slip because the price of homes has skyrocketed, in some cases doubling in the last four years.
The housing affordability index as of August 2018, which compares wages to mortgage prices, is now negative. In fact, the affordability index is now at its lowest since mid-2008. Many economists see current housing market growth as an unsustainable bubble due to stagnant wages.
3. Bond Market Bubble
The bond market is also in bubble territory worldwide. There are many different types of bonds: municipal bonds, US Treasury bonds, international bonds, and corporate bonds. Bonds can be individually purchased as fixed-rate bonds or zero-coupon bonds, or they can be purchased within bond funds.
There is a lot of demand for international bonds. Greece, Italy, Spain, and Portugal all have major problems within their respective countries, but the thirst for yield is such that insanity is ensuing in purchasing debt—corporate debt and government debt—around the world. For instance, in 2016, Argentina, which is known for defaulting, issued a 100-year bond that was almost immediately 3x oversubscribed. Investors have already lost 22% on it.
Because the quest for bond yield is so high that common sense and logic have gone out the window, the 10-year Treasury of Greece is now within 2%, or 200 basis points, of the 10-year U.S. Treasury bond, the gold standard of safety around the world. It shouldn’t be anywhere close.
High-yield bonds (junk bonds) are also overvalued and extremely expensive right now compared to investment-grade corporate bonds. Given the same maturity dates, there’s a very narrow gap between their yields, which means that investors are not getting compensated for the actual risk they are taking with junk bonds.
People appear to have forgotten that when people start selling off bonds, there’s a rush for the exit in bond funds, which affects overall markets. We can look to 2009 and 2015 for examples of this. In 2015, two high-yield bond funds went broke overnight because they couldn’t sell to meet the demands for withdrawal. That is an example of the corporate bond bubble—that’s a bond bubble.
A lot of bonds used to have “covenants” to protect the bond holder, but not anymore. Most bonds are now “covenant lite” because they’ve stripped away all those things that used to protect the investor. Your stockbroker probably won’t tell you this: the only way to find out is to read the bond prospectus.
As interest rates continue to rise, bonds will go down, and bond funds are likely to take the whole market with them.
4. Debt
Debt is perhaps the biggest bubble. It has never been this high worldwide. This includes household debt, company debt, and national debt. Experts believe that debt is the lynchpin that will cause the next big downturn.
One of the biggest reasons for the US national debt’s exponential increase was TARP (Troubled Asset Relief Program), which was undertaken by the US Treasury to mitigate the 2008 global economic disaster. This included QE1 (Quantitative Easing 1) from 2009 to 2010, QE2 (Quantitative Easing 2) from 2010 to 2011, when the Fed turned to non-traditional policies by purchasing an unprecedented hundreds of billions of dollars’ worth of mortgage-backed securities and Treasury securities.
At the same time, in an effort to stimulate economies after 2008, interest rates were lowered and kept artificially low by the Federal Reserve in the United States, the European Central Bank (ECB), and the Bank of Japan. The Federal Reserve has started raising interest rates. In the last couple of years, the Federal Reserve has no longer pumped money into the markets. In fact, they are now tapering and pulling money back. The ECB is also tapering the amount of bonds it had been purchasing as part of its QE efforts.
Among the G7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States) debt is another problem. The United States alone is $21 trillion in debt. Only two countries are higher: Japan and Italy. That’s not including state and municipality debt.
This debt is going to be very difficult to pay back. We’re only making interest payments right now, and as interest rates rise, the financial situation gets worse. There is going to be a reorganization of some type, and no one know what that will look like. At some point, the skyrocketing federal debt will matter.
Household debt is another concern, particularly student loan debt, more than 90% of it held by the federal government. According to the Federal Reserve, student loan outstanding debt rose to more than $1.5 trillion for the first quarter of 2018, less than six months after breaking $1 trillion for the first time ever.
In terms of corporate debt, there is $2.5 trillion in outstanding U.S. corporate debt that is rated BBB. According to Morgan Stanley, that’s up from $1.3 trillion just five years ago and $686 billion a decade ago—the most ever for companies rated Triple B.
American corporations have never carried so much debt relative to GDP before, and the overall quality of this credit has never been lower. The size of the Triple B-rated corporate debt market, one notch above junk, is now twice the size of the entire high-yield market.
Remember Toys “R” Us? They were Triple B at one point, and overnight they went from Triple B to D, which stands for default, cratering 70% in less than three weeks. In July, Goodyear Tire and Rubber Company was downgraded from B- to CCC+ when news came out that one of their big customers planned to drop them as a supplier. The heavily-indebted company’s bonds crashed 60% almost immediately.
While no one has a crystal ball, these four bubbles are very concerning. The unprecedented debt bubble has convinced many asset managers that we are in the late stages of the current economic cycle and are headed for a bear market.
