The Pessimism Bubble

published
2015-07-27

Economist Robert Shiller was recently quoted by Business Insider as saying

So there is a bubble element what [sic] we see. But I'm not sure that the current situation is a classic bubble because I'm not certain that most people have extravagant expectations. [...] In fact, the current environment may be driven more by fear than by a sense of a new era. I detect a tinge of anxiety and insecurity now that is a factor in markets, which is quite different from other market booms historically.

As I discussed in  Why is it so hard to find good investments lately?, I also believe we are currently in an asset bubble in which it is particularly challenging to find good investments. In that post I argued that consumer prices were undervalued, but I never felt satisfied with that statement because it didn't point to an actionable way to profit from the current situation.

I think Shiller and other commentators are correct that the current bubble is fundamentally different than most prior bubbles. The typical bubble is driven by irrational optimism and exuberance (see Shiller's book: Irrational Exuberance). The current bubble seems to be driven by pessimism. There is some economic research to support the idea of pessimism-based bubbles and the idea is plausible in the sense that any kind of irrationality can lead to mis-pricing, though intuitively pessimism would lead to asset lower prices. Below I'll try to explain how pessimism might lead to higher asset prices.

Economically, we can divide all the things you can do with wealth into the following categories:

  1. Consume it

  2. Store it (gold, cash, land)

  3. Loan it (investing)

  4. Use it as capital for new enterprise

In a pessimistic environment, people tend to reduce consumption and new enterprise. The most defensive approach is to store wealth, but some forms of investment like treasuries are possibly even safer than storage and provide a better return, so they can also be very defensive.

After the recent financial crises, people started to shift more of their wealth into conservative investments, creating large bubbles in gold, treasuries, and investment grade corporate bonds. As the crisis abated, asset allocation started to move up the risk spectrum into stocks and real estate.

Risk Spectrum:

All the savings that people were hoarding started to make treasuries, cash, and investment-grade bonds so expensive that investors got crowded out into medium risk investments. But based on the current low interest rates, the economy as a whole is still avoiding the highest risk investment in new enterprise. If there were a lot of new enterprise formation, there would be high demand for capital, which would drive interest rates up. The Federal Reserve has some influence over interest rates, but they do not have the power to counter the global economy. The global economy's pessimism is the only reason why the FED is able to keep their rates so low.

The problem with this situation is that people don't want to store their wealth because with negative real interest rates, they will be losing value. So everyone wants to loan their money to someone else to do something productive with it. But if not enough people are creating new enterprise, there's a lot of wealth that can't find productive uses. Loaning money around doesn't create new wealth unless it ends up in the hands of the people who have productive uses for it. So the actionable way to profit from the current bubble is to borrow a lot of money and use it for new enterprise. Just as those who moved into stocks ahead of the curve in 2011 made a lot of money, if you stay one step ahead on the risk spectrum, you have the best chances.