2008 resulted from inflated cash flow. In this period, investors assumed the high profits and cash flow generated from housing loans were sustainable. Instead, those numbers were based on errant assumptions about the housing market. Those profits were restated as massive losses in the following years. In this case, the valuations looked legitimate the entire time; it was the profit numbers that were inflated.
So, where should we look for the next bubble? Investors and generals are known for fighting the last war. People looking for financial decline due to increasing student loan debt or riskier car loans are looking in the wrong places. Even the optimism in Internet firms or biotech companies pales in comparison to 2000’s tech bubble. Instead, look to the variable in the equation that hasn’t caused a recent bubble. Required rates of return (r) may be too low for some assets.
While I don’t expect a bubble, there are three areas I consider as possible sources:
- Reduced-volatility strategies: ETFs have provided access to asset classes not previously available. Low- and minimum-volatility strategies have become very popular with investors because they can lower the risk of the portfolio. While these strategies lower risk consistently, they can still become overvalued.
- Interest rates: In spite of trends to the contrary, I remain concerned bonds offer very little premium for assuming inflation risk.
- Income portfolios: Income investors often assume they will earn yield and a couple of percent, in the long run, from capital appreciation. What if the pursuit of yield has made price depreciation the more likely scenario?
Bubbles are hard to predict, and are predicted far more often than they occur. While I don’t expect any of the scenarios above to become bubbles, that doesn’t mean the CLS portfolio management team isn’t watching.
Related: Do ETFs and Moving Averages Mix?
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