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Asset Bubbles and Why they Matter

  • Sharp increases in the prices of assets
  • Great public excitement about those aforementioned price increases
  • An accompanying media frenzy
  • Increasing frequency of stories about people earning lots of money, causing envy among those who aren’t
  • “New era” theories to justify unprecedented price increases

The progressions above are consistent with most asset bubbles worldwide and should give investors pause when considering buying the next dot com joke of an asset.  Technically, asset bubbles are defined as prices of assets, such as housing, stocks, gold, etc., becoming over-inflated.  Prices rise quickly over a short period of time, and are not supported by underlying demand for the asset itself.

Central banks worldwide have greased the markets with an incredible amount of liquidity for a prolonged period of time which will, and has already, lead to asset bubbles or pricing distortions.  It can be seen in the US stock market and many parts of the US in terms of residential real estate.  Closer to home, London real estate finds itself in the same position.  In April of 2015, it was reported that a home in London was listed for £750,000 ($1,160,000).  Not too much of a shocker, except that the house was only 540 square feet and at its widest point, 5 feet!  These are the types of stories that are written about and aggrandized during bubbles.

Another inevitable outcome of asset bubbles is volatility.  Defenders of the Fed’s monetary policy argue that housing prices are less than in the bubble of 2007, or that stocks are less pricey than in 2000.  This completely misses the difference between now and then.  In the past 50 years, US stock valuations have only been higher than they are now, 10% of the time and a similar figure hold for bonds and houses.

How does this impact the average investor?  It’s always easy to look in the rear view mirror and point out tops of markets, it’s never easy, and virtually impossible, to do so in the throes of it. There’s a pretty robust case for self-insulation by investing across all asset classes, sectors, industries, and being globally diversified, with exposure to multiple currencies. Doing so is your best chance for not getting caught when that one last push hits and  prices go into freefall and the bubble finally bursts.

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