Many economists believe that it’s impossible to recognize bubbles before they pop. However, Alberto Gallo of Algebris Investments has compiled a list of the largest potential bubbles around the world today, ranked by degree of risk based on size, duration, percent appreciation, valuations, and the types of irrational behavior driving them higher.
Financial Sense spoke with him last week to discuss his research, the areas he believes are highest at risk, and how he's approaching the current investment environment.
For related podcast, hear Alberto Gallo on Today’s Biggest Market Bubbles
Bubble Characteristics
Right now, the risk is high in a variety of assets around the world.
“We’re in a world where most assets are overvalued,” Gallo said, which means “in a world where almost everything looks like a bubble, the definition of a bubble has to be changed.”
To do this, Gallo widens his definition beyond valuations and lists 10 other characteristics typically present. They are:
- This time is different
- Fear of missing out
- Sky is the limit
- Flipping
- No credit, no problem
- Buy the dip
- Borrow while you can
- Bidding wars
- The trend is your friend
- Financial engineering
“It’s not just about valuations,” he said. “It’s also about irrational behavior.”
For example, when it comes to how skewed things have gotten, investors are effectively buying stocks for dividends and buying bonds for capital gains. This is not normal, Gallo pointed out.
Where are the Bubbles Biggest Right Now?
Gallo is worried about the negative-yielding parts of the bond market, which amount to around $8 trillion, particularly shorter-term German bonds.
But, in terms of the largest bubbles he sees, the most concerning are property markets in Australia, London, and Hong Kong.
“Sometimes, the most dangerous types of bubbles develop in property assets,” Gallo said. “They affect almost the entire population of a country, while financial assets may only be important for a smaller part of the population.”
Property markets in these three locations are overheated, and we are starting to see signs this overvaluation is beginning to reverse as monetary policy shifts and there is a prospect for higher interest rates.
Not enough is being done about these bubbles, Gallo noted, and because of the widespread potential impact, these three are the largest and most worrisome.
Other areas identified as high risk for being a bubble are short VIX ETFs, Bitcoin, and FAANG stocks. Here's Gallo's full list:
Source: The Silver Bullet - Interplanetary Bubbles
What Now?
It’s important to consider how central bankers are thinking right now, Gallo said.
“The biggest missing piece in the chain here is inflation...Central banks have tried through any possible means to stimulate the economy, which worked. But what has happened is corporates and investors have gained, while job growth and wages are not going up.”
Monetary policy is a one-size-fits-all tool, he stated, and one that, if used too much, can actually increase inequality, create a misallocation of resources into financial instruments versus the real economy, and stoke asset bubbles.
Currently, central banks are choosing to blow bigger bubbles instead of pulling the plug. For investors, Gallo recommends remaining vigilant, keeping liquidity high and using hedges against a coming rise in interest rates.
At the same time, he is trying to short or hedge against those assets he thinks are very frothy and where a bubble could pop.
“Like Chuck Prince said 10 years ago, we have to keep dancing,” Gallo said. “But we’re not as reckless as the bankers in 2006 and 2007. We try to be as close to the door as possible.”
