Asset bubbles: how do they form and what happens when they burst?
Asset bubbles have been a part of the investment landscape for centuries. A review of several famous historical asset bubbles helps us build and describe a framework to understand the anatomy of these phenomena.
Within this framework, a description of several recent asset bubbles, including technology and the most recent housing and commodity problems, helps put context around these issues.
The Real Estate and Commodity Bubbles
The genesis of the housing bubble was founded in the overuse of complex financial instruments bearing higher-than-deserved credit ratings. The lethal combination of opaque financial instruments and consumer lending practices created a powder keg set off by higher interest rates in the summer of 2007.
Our unique Canadian experience was marked by a multi-year rally in commodity stocks, whose underlying prices were fuelled by emerging market demand. Conventional thinking through this period suggested that emerging markets could effectively “decouple” and continue to expand in the face of recessions in developed markets.
Evidence is provided to illustrate the return to fundamentals as bubbles burst, along with several examples of swindles that are invariable outcomes of over-exuberant speculation. For example, assets under management in hedge funds have fallen by more than half from a peak of $2 trillion as investors lined up to exit. Simply put, too many of these funds were leveraged bets on momentum.
When the music stopped in mid-2008, the speed and magnitude of the sell-off and lack of liquidity did not permit quick changes to portfolio strategy. Financial uncertainties with the world’s largest global brokerages also worsened the situation as these institutions help to facilitate short-selling strategies used by many hedge funds.
Spillover effects onto the credit markets are ongoing. This issue is of particular importance in the current market environment as the historic negative impacts on the global financial system are certain to prolong the depth and severity of the current global recession. Consumer behaviour has abruptly changed as savings rates are climbing dramatically and acting as a headwind to consumer spending and economic growth.
In looking for light at the end of the tunnel, many safeguards and policies currently in place are vastly improved from those present during the Great Depression. The long-term advantages of equity investing and prudent active management remain. The inherent risk of trying to time equity markets was explored.
Plan providers are increasingly focused on the importance of longevity and time horizons. End date funds are recognized as broadly addressing these issues for many DC plan members.
Alan Daxner is executive vice-president at McLean Budden
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the April 2009 edition of BENEFITS CANADA magazine.