November 8, 2013) — Recent market behaviour is showing classic pre-bubble hallmarks, but investors shouldn’t pile into defensive assets just yet, according to a senior asset allocation consultant.
Tapan Datta, partner and head of Aon Hewitt’s global asset allocation team, said there were four aspects of the current environment which were “raising the antennae of those who like to spot bubbles in markets”.
The first is that the market appears to be suffering from a memory lapse. Investors have endured a succession of bubbles in the past 15 years, starting with the Asian crisis in the 1990s, followed by an emerging markets bubble, then the dotcom bubble, the credit crisis, and a bonds bubble, the last of which may be in the early stages of deflating, Datta wrote.
Also, the aftermath of one bubble can easily lead to another. For example, US interest rates were “much too low” in the aftermath of the dotcom crisis, forming the credit bubble. The burst credit peak then sowed the seeds of quantitative easing and the zero interest rates-inspired sovereign bond troubles.
And central governments struggling to turn off the easy money taps could lead to the next bubble in risky assets, Datta said.
“Such reasoning needs a strong and skeptical memory, but this is less and less in evidence,” he said.
The second and third pointers are linked: the belief that “this time will be different”, and the markets’ desire to put off thinking about unpleasant issues.
“This is a kind of ‘cognitive dissonance’ a term used in psychology to describe situations when we have conflicting beliefs, but to achieve harmony we prefer not to think about the unpleasant aspects e.g. a smoker who knows the risks of cancer,” said Datta.
He cited the recent taper tantrum of May and June as a perfect example: the markets knew quantitative easing could not last forever, but at the first sign of its withdrawal being considered, they panicked.
The fourth sign that a bubble might be on the way is when markets take news that should be considered as bad news, and present it positively.
The US shutdown was bad news, but markets barely fell—even when the atmosphere in US Congress was at its most febrile, he said.
“The strength of the ‘taking bad news as good news’ tendency explains why unusually, bonds and equities have been spending much more time moving together this year instead of in opposite directions,” he argued.
So should investors pile into defensive assets and batten down the hatches? Not just yet, Datta advised.
“For now, heed the warning signs and turn sceptical, resisting the ever stronger bullish undercurrent in the markets. Remember the unfortunate market history of the past decade and a half,” he said.
“Ask tough questions to those who say it is different this time. Be especially wary of bad news being interpreted as good. Make plans to review risk and re-affirm strategic asset allocation targets. And allow flexibility in one’s investment approach—things will need to be moved if these signs of trouble multiplied.”
The full blog can be read here.
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