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The Bubble Theory

Unless you have been living off the grid in Montana, you know that the market has been declining for the past two months.  In fact, the market peaked last summer, and was in a slow, steady decline for the second half of 2015, and the pace of decline accelerated in 2016.  But why?

The truth is that no one really knows, but here is my theory.  The biggest underlying driver of this market decline is… bubbles.  When I graduated from college in 1998, the term bubble as I knew it referred only to the soap and water mixture that my kids now love to play with.  Since then, the term bubble has been increasingly used to describe the irrational behavior that investors sometimes exhibit.  During my adult life, we have seen a series of bubbles, all of which have come crashing down as bubbles so often do.  I’m sure there are some underlying reasons why bubbles seem to be forming and popping in the modern era more so than at any time in history, but regardless, it is happening.  First, we had the dot-com bubble from 1999-2001.  We all remember how that ended, and most of us who are old enough probably lost some money in the debacle, or at least know someone who did.  Well, apparently we didn’t learn our lesson, because in 2003 I started hearing from everyone that I needed to buy a house.  Why?  Not because there are so many benefits from home ownership, but rather because I could make a huge profit!  What happened next?  The housing bubble is what happened.  That all came crashing down in 2007 and 2008 during the financial crisis. 

My point in bringing this up is that for those of us in my age range (35-45), our entire adult life has been defined by a series of periods of irrational run ups in the price some product, followed by an inevitable crash of the price of that product, followed by a period of economic recession.  This has created a fear of anything that seems to be enjoying a period of sustained increases in price.  Everyone knows the old saying that what goes up must come down.  After seven years, people are nervous that this current bull market is just another in the series of bubbles.  However, just about the only thing from the Janet Yellen testimony this past week that I agree with is her statement that “bull markets don’t die of old age.”  There is no historical evidence to suggest that this has ever happened, nor would it make a lot of sense. However, that doesn’t stop the fear from creeping in or investors from trading on that fear. 

This fear is also the reason that the market is reacting to every piece of news like it is bad news.  What do I mean by this?  The best example is oil.  The price of oil is down about 80% from its peak of about $140 in 2008, and down about 75% from its peak of about $114 in 2011.  A large percentage of companies in the world use oil, in one form or another, as a raw material in their quest to make a profit.  If they can now buy that same raw material for 75% less than they were during the middle of the bull market, shouldn’t that be a net benefit for their profits?  Not only does it benefit companies by adding to their bottom line, but it also benefits them from the demand side as well.  What do Americans do when they have extra cash in their pockets from not spending as much on gas?  Do they save it?  Heck no! They go out and buy things!  It’s the American way!  So low oil prices benefit many companies by lowering their costs and increasing the disposable cash that their customers can spend with them.  So how is this bad for the economy? 

Fear is also driving the rhetoric about China.  First of all, the China news isn’t breaking news, I first learned that their growth rate was unsustainable from one of my favorite professors in business school in 2001.  If he was able to warn me about it 15 years ago, and even the cable news networks have been talking about it for close to a year now, how is this news?  Not to mention, their economy isn’t shrinking, its growing at a robust 6.9%!  If our economy were growing at 6.9%, Janet Yellen would be hiking rates so fast that we would have Carter-era mortgage rates in no time!  Exports to China account for less than 1% of the United States GDP, so while I understand that China is a key market for some of our larger corporations like Apple, does the fact that their growth slowed last year really drive the value of American corporations?  My argument would be no.

And lastly, the Fed.  I have never seen so much discussion over a non-event.  What, outside of a 10% decline in the stock market, has happened since the quarter point rate hike in December?  Did mortgage rates go up?  Nope, they went down.  Did your savings account yield increase to a point that you don’t need to take risk in the stock market?  Mine didn’t.  Did auto loans go up to a point that people can’t afford to buy cars?  The record sales set by automobile companies recently would say that hasn’t happened.  Besides, Yellen spent almost a year warning us about this.  It should have already been priced into the price of stocks.  If it wasn’t, then the market isn’t as efficient as we give it credit for.  This is just another example of investors trading on the fear of continued rate hikes.

So don't buy into the hype.  Stocks can go higher, and the economy isn't on the brink of recession.  Everything isn't a bubble.  One of the best warnings signs of a bubble is when people who have no understanding of a market are investing in it to make a quick profit. Think about 2001, you couldn't go out in public without hearing a conversation about tech stocks.  In 2006, you couldn't find anyone who wasn't flipping real estate.  Is everyone talking about the stock market today? They certainly aren't, and if they are, they are wary of it. That is just one more reason I don't believe we are in a stock market bubble.