I am reposting this information. I wrote this and released it originally on here, January 14th, 2022. It is a long post but that’s sometimes required to educate on an important topic, especially if you have money at risk in financial markets. Hopefully, you can benefit from timely information like this, applicable to our world, especially now, four months after the fact. Economies and markets are dynamic, and I would like to arm you with information you CAN use… no one will ever accuse me of not having vision. Read this —->

Now that’s encouraging right? I’m not certain how to use this information but it’s calming to know that looking at what happened in the past maintains it’s level of accuracy, even if people do not. While forecasts, albeit produced by well-minded individuals, are often fraught with error. Forecasting has to be one of the hardest ways to make a living because very few can read tea leaves, or at least not with much accuracy.

So with that said, I wanted to look into how asset bubbles form in the first place, and why few of us can detect when some unsustainable situation has formed that is feeding the bubble, until such a time that the bubble finally bursts. And why do bubbles necessarily cause “contagion”? And can someone who is not even a participant in a closely related activity still protect themselves? How about their job and their income? From peripheral damage(s) when an asset bubble bursts? Especially when such bubble appears far removed from anything to do with them? You’d be surprised at the answer. So here, now, I’d like to talk about these kind of things. These are things that whether you ever aspire to manage money or not, you can still be miles ahead of someone who ignores these incidences thinking naively that they will never be affected. Maybe by having a better understanding of the connectivity between world financial markets, public corporations, and government(s) when asset bubbles form in the future you might have an understanding of how their resulting price implosions can affect your life and the life of your loved ones. So let’s get started.

A “Paradigm Shift”, an important concept in economics, describes a fundamental change in “operating rules” or sentiment. Paradigm Shifts have far-reaching consequences evidenced sometimes by changes in public policy or sudden swings in investor sentiment, or both. It’s a shift large enough to move financial markets and affect the outlook for entire industries both positive or negatively causing almost immediate consequences in investor sentiment and behavior. It is helpful to understand when a paradigm shift has ocurred. One example of a paradigm shift could be when the Federal Reserve changes its stance on Monetary policy, say from a very dovish, easy money stance and subsequent years of running stimulus programs, to one where they suddenly switch to tighter monetary conditions by turning off the easy money spicket. The Fed can accomplish this in a variety of ways, one way being “Open Market Operations”. They can raise short-term interest rates since they control that part of the yield curve. Higher short-term rates will spill through the economy and affect the costs associated with of all kinds of borrowing. Why are we spending so much time on Paradigm Shifts? Because sometimes when they occur they can expose bubbles in the economy and fairly quickly – that’s why.

The world is full of risks, I’ve mentioned that fact before – all adults know that just waking up in the morning is a risk in itself. We humans face risks in all facets of this life. But we have to take risks, as they are essential to getting things accomplished in life as there are really few guarantees. Most things that carry guarantees aren’t that attractive anyway, hence can we claim that money mimics life somewhat? 🙂 Asset bubbles in the economy do not develop overnight. Creating something “unsustainable” is usually a long process of daily activity that can begin by making fundamental sense. It’s not like asset bubbles form by totally illogical thinking, not in the beginning anyway. Very seldom are these totally illogical, it’s just that they can become illogical over time. The hardest thing to do as an Advisor is to talk someone out of holding something that’s been working for them. It’s nearly impossible even if you see eminent danger brewing most investors will shrug it off as an irritation, or just you being the self-centered one. Afterall, don’t you want them to feel good anymore? LMBO!

When real estate prices bubbled up in the early 2,000’s, one must remember that previous to this ocurring a tremendous amount of wealth was lost when all things “internet” imploded just what, 6 or 7 years earlier? This incident resulted in a full-on bear market in U.S. stocks across all sectors of the economy lasting for several years if not a decade [depending on how you measure underperformance for the S&P 500.] And all the while real estate, which was less attractive during that particular stock market bubble, suddenly became attractive. Especially once then President Bill Clinton publicy urged banks to offer “non-verifiable” loan products. With that in place real estate suddenly was in high demand [a paradigm shift ocurrence], from detached homes to vacation condos to you name it, it seemed like everyone was wanting to grab their piece of the pie. Many people bought up multiple properties because there now existed an attractiveness of owning real estate over investing in stocks. As a matter of fact, I myself moved my family into a larger home at the very beginning of 2001 with this concept in mind. Stocks, who needed that stuff? And of course by late 2007, we all know what eventually happened as banks and mortgage companies began to fail. Turned out that these “new-fangled” Alt-A, Subprime, and other non-verified loan products, led by Bill Clinton’s new policy, led us into the worst recession America had witnessed since the stock market crash of 1929. Many people bought up multiple properties thinking that all this was going to lead to ever higher prices, and since they’re making no more land, it surely would never end? However, end it did, and it placed our nation’s largest lenders at the brink of insolvency. Had it not been for the rescue effort by our Federal Government and the Federal Reserve, many more banks and brokerages would have surely gone under, and disappeared.

Once the recession hit, the contagion spread through about every corner of the economy. However, it may interest you to know that there were a few places where employment and incomes were either preserved or even escalated during the downturn of 2007 through 2009 as there will always be winners and losers during any economic downturn. The stock market itself, measured by a broad-based index average, finally bottomed out in early March of 2009. I think the day was March 9, 2009, and from there it made a very slow, albeit painful recovery. Consequently, two sectors of the economy did very well through that whole nightmare known as “The Great Recession of 2008”. The two industries that were insulated as I recall were healthcare (physicians and their staff et.al.) as well as the sector known as money management. I had neighbors and friends that thought surely I would be laid-off in the “Great Recession”, especially since the stock market crashed and most large banks were having to be bailed out? Nope – not at all, my business grew all through the “Bill Clinton-esque Great Recession”. People relied on money management folks for advice and now they were even more engaged/interested in getting their financial lives back in order. Afterall, they just lived through the dissolving of the internet bubble followed by an enormous bubble burst in real estate, and subsequent recession, all within the same decade. It was a tough time and financial advice took precedence over a whole lot of other things. I would suspect that may hold true going forward as well. However, as a side in the interest of full disclosure, the regulatory environment in these two industries I mentioned – healthcare and financial services, has changed enormously since then, hugely, while potential incomes have simultaneously decreased, making these two career paths much less attractive (in my most humble opinion) than they were before. And just think, “Bill-Clinton-built-that!” 🙂

Asset prices do bubble up from time to time. Over long spans of history operating under a “free and open market” economy, and asset bubbles will form on occasion. They are more common than most people think, especially under the leadership of Federal Reserve “easy money” policies. Because Fed Stimulus Programs essentially “distort” asset prices, they always have, this is a known fact. That’s the problem with letting the Fed provide the “medicine” to keep the U.S. economy afloat, and reduce near-term financial pain. Nearly always when stimulus is stretched out over time asset price distortions show up inside a host of financial instruments. The fact that too much money is sloshing around trying to find a home kind of exacerbates the formation of an asset bubble. Price itself is never a catalyst in an asset bubble forming for if it were price bubbles wouldn’t exist right? Think about that statement. Something else happens that causes a certain asset either to become extremely attractive to hold, or to become avoidable at all costs. Again, these are usually rational decisions that investors make that only over time become “irrational”, and always to the detriment of that same general public. Returning to “how hard it is to talk someone out of what’s been working for them”, especially someone untrained with little knowledge base for what they’re actually holding onto and how things have changed during the time they have held it, etc. People will have a tendency to ignore change, or believe that any change cannot possibly affect them.

So now that we admit to these asset bubbles and how on the way up the climb is so much fun, but how did this all come crashing down and ultimately “make more sense” – all at the same time? And explain again, how can I be affected if I didn’t own this stuff in the first place? “Contagion” is one of the hardest realities to stomach once a asset bubble finally pops. The fact is that financial assets are inextricably connected to a ton of other realities, it’s all good when things are moving up in price but can get really hard to watch and stomach when prices fall or even crash. That’s a good reason to at least look out for “unsustainable situations”, or asset bubbles.

All these financial markets are essentially “auctions”, in order to sell or trade something away, you have to find a buyer. Wall Street has made that easy by the use of electronic trading, it can appear almost instantaneous, but behind the scenes whatever you entered a sell order on was scooped up by a buyer on the other side of that trade. Auctions are characterized by having two sides in any transaction. That’s the description of an “efficient market”. However, what happens when there are way more people wanting to sell than buy? You have lopsided order flows, as buyers become much more difficult to find. So unless you’re willing to take a much lower price, which describes what’s taking place during a market “crash” or the popping of an “asset bubble”, your sell order is not getting filled, or certainly not at a price that you would find attractive.

Financial markets are nationwide and aggregated thus it can be determined roughly how many dollars are being held in a certain asset class category or sector of the economy, commodity etc. This is where contagion can take place. You and I are not privy to all the individual holders of a particular asset, or even how they acquired it. For example, did they put up collateral to hold that position? Collateral in the form of other financial securities? If it’s an institution or a hedge fund it’s very likely that they could have pledged other holdings against that position. So now we see that leverage can play a substantial part in the existence of an asset bubble. Conversely, many lender(s) could be involved (and loans needing to be paid back) when it’s time to exit a certain investment strategy.

Currently, dollar equivalent holdings in Crypto currencies around the globe is approaching $3 trillion. The market capitalization of Bitcoin alone exceeded $1 tillion dollars, and that was one year ago! I do not own any crypto currency positions, never have. I have had a couple folks inquire as to why I have never purchased a crypto-currency? My answer was simple – retirement was my most recent financial goal and I simply never needed them in order to retire. However, looking at the amount of dollar volume held in these today, am I going to be naive enough to believe that if every one (or most) of these investors headed toward the exits, that this asset bubble won’t result in a ginormous contagion, and spill over into otherwise established financial market instruments that I might own? Don’t kid yourself. Even if half of the purchases in cryptos did not involve the use of leverage (via collateral) sparking widespread sell programs to trigger on Wall Street, the very fact that individuals in these could have little value left to liquidate most likely will require them to sell other financial holdings that are listed on major stock exchanges. This event could trigger a substantial sell-off on Wall Street just to satisfy the need for immediate cash… in other words, a contagion event. Of course loans called must be satisfied which further exacerbates the selling of other assets. We’ve seen this play out time and again. This is how recessions begin, a contagion sends financial shocks through markets affecting both large and small corporations as well as individuals which triggers layoffs as all excess capitol dries up. Therefore, I’m very concerned when I suspect a bubble forming in financial assets because large bubbles like these do not pop “privately” – it’s quite the opposite, and contagion makes certain of it.

[As an aside, I’ve always been in the camp that crypto-currencies were born out of the fact that banks were unable to pay dividends, even years after the “Great Recession” of 2008 [via Federal Reserve mandate]. Therefore, there simply wasn’t much in the way of bond interest or interest being paid on cash deposits for that matter, and for years. Interest rates have followed economic growth in this country, and they both shrank at the same time. Now today we have witnessed the emergence of crypto-currencies, with thousands and thousands of them to choose from. To many people, I guess these provided a substitute for getting paid on their cash deposits as opposed to storing it inside a financial institution and getting paid virtually nothing? [no pun intended]. 🙂 Like I mentioned earlier in this longest of blog articles, Federal Reserve Monetary easing measures, originally meant to stimulate economic growth and with good intention, often results in the emergence of asset bubbles… history is probably the best teacher we have yet we all have a tendency to ignore its many lessons even though those lessons are always available to us, and for free I might add! ;)]