THE LONG VIEW

Dambisa Moyo

Two factors can serve as early warnings of where and when a financial-market bubble might burst , and whether it will hurt the economy .

HE SIGNS OF BUBBLES EMERGING IN FINANCIAL MARKETS are clear to see . The Dow Jones index recently surpassed 40,000 for the first time , and the U . K . FTSE 100 and French CAC 40 also have reached new highs . Forward price-to-earnings ratios in the United States are trading at a multiple of around 25 — well above the historical average of 16 — and these high valuations have persisted despite interest rates above 5 %.

Such trends certainly justify worries about new stock-market bubbles . But not all bubbles are equal , and only some are problematic for the wider economy . What matters — as we saw after 2007 — is whether a burst bubble will trigger a chain reaction that undercuts growth for years thereafter .

From an investment perspective , two factors can provide an early warning of where and when a bubble might burst , and whether it will be followed by a market correction or broader economic crisis . The first is the underlying or intrinsic value of an asset ( whether it is productive or unproductive ); and the second concerns how that asset is financed ( be it through equity , cash or a substantial degree of leverage ).

With this two-factor framework , we can evaluate four types of bubbles . The first — and least dangerous for the wider economy — involves a productive asset primarily financed by equity or investor cash . Think of an equity investment in a telecommunications or broadband cable company . If the bubble bursts , the lost capital will be largely contained or ring-fenced among the direct investors ( those holding the stock ), without many spillovers to the wider

What matters — as we saw after 2007 — is whether a burst bubble will trigger a chain reaction that undercuts growth for years thereafter . economy . Moreover , telecoms / cable companies hold tangible assets with intrinsic value , which both limits the downside risk and represents upside potential for when the economy recovers .

The second category is a bubble of productive assets funded by debt , as when corporations take on debt to finance their operations or remain a going concern . In this case , a bubble bursting can have systemic implications , because large losses will reverberate through the banking system or capital markets , ultimately slowing the economic recovery as financial institutions work through their losses and reduce lending . However , the losses to the economy will be limited , because this scenario still involves productive assets .

In the third scenario , unproductive assets are funded by equity or cash , as in the case of much cryptocurrency investing . Here , the underlying asset is unproductive in the sense that it will not yield a future cash-flow stream . If it falls in value , there is no fundamental basis — business or financial , such as hard assets — from which it can recover . But like the first category , the equity / cash financing implies that the spillovers will be contained .

That brings us to unproductive assets financed by debt . The prime example is the subprime mortgage crisis that erupted in 2008-09 . An excess of housing meant that the underlying asset was unproductive — uninhabited homes will not yield future cash-flow streams — and the manner

20 | FINANCIAL ADVISOR MAGAZINE | SEPTEMBER 2024 WWW . FA-MAG . COM