In this episode of Markets in Focus

Bubble trouble is on the minds of many investors as markets reach new highs, meme stocks and digital currencies take off, and fears of inflation creep in. The big questions include: Are we in a bubble, and if we are, is it possible to still invest wisely? Matt Orton, CFA, Director and Portfolio Specialist at Carillon Tower Advisers, asks Jason Richey, CFA, Portfolio Manager at Cougar Global Investments, to address these bubble worries and more.

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Transcript

Matt Orton:
It seems that one of the most used words so far in 2021 has been, "bubble," and that tends to conjure thoughts of the medieval tulip mania and the 1999 to 2000 tech run. However, what I want to start with are the basics since it seems that no one ever really asks the simple question, what really defines a bubble? And here to help us answer this question is Jason Richey, Portfolio Manager at Cougar Global Investments.

Matt Orton:
This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends and developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights. Thanks for joining us.

Matt Orton:
Thanks for joining us today, Jason.

Jason Richey:
Yeah. Hi, Matt. Great to speak with you today. I really appreciate the invite.

Matt Orton:
No, of course. So let's start with the basics. So what would you define as a bubble?

Jason Richey:
Yeah. Look, in terms of bubble, I think the beauty of using the word bubble for us in the financial world is that we tend to use it as a crutch for something that doesn't make sense, or it's an easy way to explain away the essentially unexplainable. That's really because we have 100 years of very robust market data measured in a thousand different ways. So when a security or an asset class doesn't act the way that it should or you can't justify it in any fashion whatsoever, it's fairly easy to chalk the entire situation up as a bubble.

Jason Richey:
Now, in terms of resources, there are a number of books on bubbles and finance. One of the most recent is titled, "Boom and Bust," and that was published last summer. It was written by a pair of academics, and they take us all the way back to the 1700s and they walk through a series of bubbles and they argue that the word bubble going back to the 1700s was used as a verb and it meant to deceive. They also tried to explain how to spot bubbles and they argue that financial bubbles come from two sources, either technological innovation or government policy. I think it's fair to argue that both of those categories can fit the environment today.

Matt Orton:
Yeah. That makes a lot of sense, and that's an interesting point you brought up about the way they can be brought about. Just like you said, given the environment we're in with really unprecedented fiscal spending and tremendous amount of technological innovation, would you say that the market, broadly speaking, qualifies as a bubble?

Jason Richey:
Well, let's look at both of those categories the two academics referenced. First, technological innovation. That immediately makes me think of Bitcoin, or digital currencies, or perhaps the ease of data and information flow driving these one or two days’ worth of market action that we've been seeing lately in certain mean stocks. The other category is government policy, which we spend quite a bit of time on here and it's impossible to overlook either monetary or fiscal policy and just consider where we are at this moment in time. We have the potential for likely higher than 6% GDP growth in calendar 2021, which we haven't seen those types of numbers since the early eighties and we also simultaneously have a Fed buying $120 billion worth of bonds every month to theoretically support capital markets.

Jason Richey:
On the fiscal side of the coin, we have a 20% savings rate, which amounts to more than a trillion waiting to be spent by consumers. The bottom line is that when there's an ample amount of money available, which is certainly the case today, that money will find a way to create mischief and the potential for financial instability. So yes, if you're investing based on valuations or earnings potential, there are certainly signs of bubbles. But the interesting element to me is whether or not we would even see another one of the broader classic 2000 to 2002 type two and a half year 80% draw down that we saw back then at a tech stocks, or if based on our experience last March, and even going back to the 2008 crisis, if government officials just simply throw a bunch of money and soothing words at various markets, maybe any 30% or a potential 40% loss would immediately turn into a 10% loss or perhaps break even.

Jason Richey:
So then, I think the question is a bit more philosophical in nature, and that, and that would be, would that even count as a bubble if the whole round trip takes place in a couple of months or something less rather than two years?

Matt Orton:
Right, and I think that's a very important distinction to make because there might be shades of correlation between past bubbles, but the drivers and the way they act is very, very different. You had referenced different pockets of the market potentially maybe looking like a bubble. So the obvious first place to start then is what we've seen happening from the Reddit trade or the Reddit rebellion as a lot of people call it. Many of the names were up thousands of percent and a lot of them have crashed already, but we're still seeing some unusual activity take place in certain stocks in the market. If these are a bubble, maybe you can comment on that. But what do you think are the risks of these sorts of trades to the broader market? Or do you think that it really is just truly one-off events that will not have meaningful implications for the market as a whole?

Jason Richey:
Yeah. I think it helps explain why the VIX, why the volatility index is, seems stuck above 20. It's been there for a while, and that index also, at least lately, seems to spike fairly quickly on what aren't very large moves in the equity market. So to me, that's a sign of a jittery market that can't quite put its finger on why it's so jittery. But I think you're right. It seems to be a sort of rolling blip through a name or two at a time. So I think it's easy enough to call the Reddit factor itself a one-off. Now, from a market structure or a behavioral point of view, one of the big implications involves the hedge fund industry and how it approaches risk. You saw a couple of notable short sellers disengaged from the industry.

Jason Richey:
Now, I don't think short-selling as a whole goes away, but hedge funds have immediately changed their models to account for that potential momentum of social media on any given single name. There have been a few high paying chief sentiment trader positions I've seen whose job I suppose, is to monitor some of these online forums. I doubt there's a huge movement towards taking on a lot of additional labor costs in this environment, but it's clear at a minimum, risk models are being updated. So I'm not ready to use the Reddit argument as the entire reason for financial instability, but I'm very willing to throw it into the larger bucket of sources of potential risk or sources of potential instability that we need to pay attention to.

Matt Orton:
Extending from that, what about some of these other areas of the market that have been impacted, I would say, either alongside the Reddit trade or share a similar, I would argue, speculative nature to the rises that they've had, call it a Bitcoin, for example, or some of the cryptocurrencies like Dogecoin that seemingly just go up for really no reason at all?.

Jason Richey:
Yeah. I think there's plenty of easy targets. Everybody else picks on celebrity SPACS (Special Purpose Acquisition Companies). I don't have to. We're more than on pace for a record year of issuance, of SPAC issuance that is. I do think it's interesting that there's a rap song about SPACS that made the front page of the Wall Street Journal. I just find that interesting. I think you could pick on municipals like the city of Detroit issuing bonds it's 20 times oversubscribed, but at the same time, every investor is chasing yields. So it actually makes some sense to me, especially when you consider the ever-present Fed standing behind you as an investor. But I'm going to go a different route and topics important to us, which is first, a bubble and Fed following.

Jason Richey:
Now, I don't know how much more analysis you can do when you get to the point where you're analyzing the various adjectives the Fed chair uses either in his press conferences, his speeches or any of his formal statements. So they are market moving if you're a very short-term trader. I understand it, but I think the bigger point is just how involved the government is today, and I don't know that they ever wanted to be in this position. I don't know how we're going to get out of it, but that's sort of the reality of where we're at. It's hard to do, but if you're investing in anything longer than, let's say, a five day timeframe, just try to be careful not to get sucked into the endless reams of Fed analysis and do your best to see the forest through the trees and try to stay on top of the larger trends taking place.

Jason Richey:
The second bubble, at least in our space that's important to us is all of the new exchange trade funds. So I read an interesting academic paper. It tried to explain pace and the amount of ETF closures taking place the past year or two. There's some correlation with performance as you would expect, but what the paper found was actually the rise in thematic investing and the launch of thematic ETFs. That can work for a year or two in the very short-term, but it doesn't last very long leading to some of these closures. Remember, it wasn't that long ago. It's less than 10 years, really, that there was still plenty of questions about the direction of the ETF industry overall. Now today, you have a situation where the marketplace is almost overly competitive, I'd argue, especially in the US, given the ETFs are launched and then closed after just a year or two. So just be careful with some of the thematic ETFs. Again, depending on your own investment style, they can work great for a while, but they can experience draw downs and outflows and certainly be impacted by social media.

Matt Orton:
So I want to dig into that thematic ETF topic just a little bit because I think some of the thematic ETFs have been poster children for the runs and some of the spectacular, I'll call them, bubblelicious type companies. Ground zero might be the arc group of ETFs where they're focused in different innovators back to that tech innovation theme you were talking about. But I think what gets ignored sometimes is the impact of these ETFs on broader indices as well. So maybe you can share some thoughts on the potential impact of these ETFs as they get strong inflows to impact the market. Then I'll probably have a follow-up question from there.

Jason Richey:
Yeah. The ETF more so... Again, with the ETF market maturing the way that it is, I would argue it's overall a good thing. You just have to be cautious again, in some of these thematic ETFs because it's hard to get the size needed to make these things very profitable at these low expense ratios, which is fabulous for investors. For example, one of the vehicles that we pay attention to is the Bitcoin vehicle. In Canada, we launched a couple of Bitcoin ETFs to get back to your point about Bitcoins. Now, we still don't have an ETF available in the US quite yet. I'm assuming that'll happen eventually. And again, that'll probably get a lot more interesting to us because it'll mean that crypto is an asset class, or I suppose you can label it as an asset class because it's available to a much broader audience.

Jason Richey:
But in terms of market dynamics, if you looked at the individual companies now holding Bitcoin in lieu of cash on their balance sheets or payment processors, or eventually everyday wealth managers like us having access, I think that means the Bitcoin or crypto has staying powers. I realize I'm referencing a very specific slice of the market. So this is where some of those niche ETFs may work. It's not the case for all of them, but I think specific to Bitcoin, regulation is always the question. I think some regulation could actually be a good thing. My guess is if we had acceptable rules of the road, that would take away from some of the volatility of Bitcoin.

Matt Orton:
Moving even beyond Bitcoin and the impact of some of these ETFs, I look at the small cap and really, especially the microcap space as being potentially influenced by flows into some of the thematic ETFs. Microcaps especially have been on an absolute tear, I'll call it, since Pfizer day in early November. Maybe you can comment a little bit on the massive run that microcaps have been on and whether or not you think this is a potential risk for the market because to me, the run of low quality, smallest of the small companies reeks to your point of a market, a wash in liquidity, and perhaps a misplaced speculation.

Jason Richey:
Yeah, we called it vaccine weeks here because it was not only Pfizer, but it was successive weeks. It felt like November... Which is why November was such a great month and ended up being the a record month for small caps to your point. It's a great topic particularly relevant to us and something we've been debating for a while. I'll just throw it into the small cap versus large cap buckets. Now, we've been using small caps as a whole, as an indicator of a broader recovery and bullish sentiment for exactly the reasons you mentioned. Now, to be fair, it's always been the case that small caps and especially microcaps, a significant portion of those companies have no earnings or poor earnings from a quality perspective. So that element is not unusual in and of itself, but the reason is drawing so much attention now is because of the bounce that we've seen in the past few months, especially when you consider we had the best month and we had the best quarter in the history of the Russell 2000 index in the fourth quarter of 2020.

Jason Richey:
Now, once you get that type of performance, I think all eyes shift to immediately explaining it and then justifying it, which is why I think you see such a focus on their earnings or actually the lack thereof. Now, again, all roads lead to the Fed. So it points to a very supportive Fed, which if you have access to capital, then that buys these smaller companies time to start eventually generating profit down the road because they don't need it to pay the immediate bills now. So I recognize the small caps have been on a run lately, but large caps have been winning for a long time now. You have to go back five years to 2016 to see the last time that small caps outperform large caps. So I'm less worried about small cap performance in the bigger context.

Jason Richey:
Although, I spent a lot of time on small caps, I agree with your thesis. If you're picking individual names, be very careful in this space, especially in the microcap space. That space is not my cup of tea, but we're not trying to pick any individual securities. So we get the natural diversification of the entire basket. But in general, if you recognize that the US is ahead of much of the world in the vaccine race in recovery, then the more domestically smaller cap names make a lot of sense.

Matt Orton:
Yeah, I think that's some great context to bear in mind. So I guess we'll say small caps, even though they're up 122%* from the bottom on March 23rd through the end of February in the Russell microcap index 150% just about, well maybe shades of bubbles in certain areas, but it makes sense in the greater context of what's happening. Maybe one other area we can transition to is looking at what we're seeing in the debt markets as well. There's been a surge in demand over the past six months for, I'll call it, much more speculative debt lending to CCC and below companies. What do you think about that? Are you concerned about any of that right now?

Jason Richey:
Yeah. Again, on the face of the argument, yes, there's concern. The example I'll use is anytime that you have a newspaper company, you get the opportunity to refinance a loan at under 8% and save more than 350 basis points of interest costs because their old loan used to be 11.5%, I think that should give you an indication of the amount of capital that's available right now. But again, if you think the Fed will always have your back, then a yield reach isn't all that bad. Investors have been reaching for yield for a decade and that strategy has largely paid off. The high yield index, the corporate index is provided double the annualized return of the Barclay's aggregate index over the past 10 years. So there's no question there's been hiccups along the way, but the strategy of relying on the Fed hasn't been a bad one.

Jason Richey:
Now, again, in the high yield space itself, it seems every couple of years we talk about refinancing cliffs, but the financing always seems to be there. As we saw in March 2020, it's always very easy for monetary policy to step in as necessary. But microcaps, CCCs, I think you're talking about some of the, I'll call them, less than mainstream asset classes, which are often by themselves in either boom or bust mode just depending on where the economy is at. So now, we'll have to see whether credit spreads themselves are decent indicators because spreads have been very quiescent for months at this point. So they're not indicating trouble ahead. Now, if you see those credit spreads pick up, then my guess is they'll probably move very quickly. So I don't know if you'll have time to get out of the way, but watching credit spreads, especially at the lower end, is something that most macro investors monitor as an indicator in today's world.

Matt Orton:
Yeah. So I guess maybe the next question is when you look at what's been happening in the market, especially based on the past month or so of gradually, and in some cases, sharply rising rates, what happens if it's clear that economic growth is in fact accelerating and it's far ahead of what we were expecting and there might be whiffs of inflation coming? What happens to a lot of these trades?

Jason Richey:
Well, okay. So given the amount of stimulus that's either already in the pipeline or likely to come, my guess is I don't think we're going to see weaker economic growth, at least in the US, but if we do see weaker growth or if we got another surprise on the variant front, I think the simple solution is that we just get more stimulus, which is the beauty of having the reserve currency. So I don't think weaker growth as much of a risk, but we certainly could see stronger inflation, which in theory, that would be as a result of strong growth, which should be good overall. Now, if we see higher rates and we see higher inflation, then those growth of your names that lack those current profits would struggle, and we've seen that already happening in the market recently to your point.

Jason Richey:
Now, many would argue that the run that we've seen in Bitcoin or crypto has been a result of a declining dollar or perhaps the availability of money. So I think you'd probably see those go higher as they have been, again, any bombshell regulation that comes out. But if you dig into the calculation of inflation, the last time that we saw core inflation above 3% was 1995. I think a little inflation would be more than welcome at this point, and that's certainly the Fed's stance. Now, we've seen asset price inflation without question, but based on the purely economic definition of inflation, we just haven't seen it. Now, that causes its own problems if financial assets inflate, but the real economy doesn't, but that's really just a limitation of monetary policy almost by nature.

Matt Orton:
Absolutely. So, Jason, I kind of want to take everything home and wrap things up as neatly as we possibly can. So we've talked about what constitutes a bubble, different areas of the market that look like they could be in a bubble and reasons potentially for that, but one question that I think most of our listeners want to know is given where we are in the market, how do you prudently or properly invest in this sort of market environment?

Jason Richey:
Which is the million dollar question, right? That's the interesting question. So if you have a financial plan, if you have a longer term timeframe, then I think the usefulness of recognizing and identifying potential bubbles is mostly a psychological exercise, which I think it gets to the heart of your question, which is what do you do as an investor? Since I think we can reasonably identify various bubbles, but we can never really know the timing of when the bubble may pop. I think the simple act of merely recognizing the potential for a bubble, at least from a psychological point of view, that can prepare you to stick to your plan if and when that bubble burst.

Jason Richey:
Now, whether that plan is to be prepared to buy more of a particular asset class after a predetermined drop, whether that's rebalancing more frequently or even if that plan is doing nothing and just refusing to log into your accounts and check your balances, if you have a plan, and more importantly, if you have confidence in your plan, then I think not only are you becoming a more alert investor, I think you're in a much better place to act and invest wisely. Now, on a lighter note, the only caution I'd have is that if you start identifying bubbles and you try to avoid them, then you run the risk of being called a party pooper, which I get labeled that every once in a while. But the bright side is you probably won't end up at some future congressional hearing, which to me, I personally consider that a good thing.

Matt Orton:
Well, I think that is excellent advice. Have a plan. It sounds simple enough, but probably some of the least heeded investment advice around. Jason, I really appreciate your time. This has been a great discussion. Thank you to our listeners and take care.

Matt Orton:
Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.