A head strategist at JPMorgan lays out the 5 traits that can help you spot a bubble on the brink of bursting

REUTERS/Brendan McDermid

• John Normand, JPMorgan's head of cross asset fundamental strategy, says he's found five traits that are shared by all kinds of market bubbles.
• Fears that bubbles are forming in the market have grown more intense as stock and bond prices have both recently hit all-time highs, which helped send other asset prices skyward.
• Normand rejects those fears, saying that - although it's very difficult to identify a contemporary bubble - he doesn't believe there are bubbles in any major asset classes today.
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Whenever a stock, asset, or new investment makes a huge gain or becomes popular, you can bet someone is going to call it a bubble.

To start with, there's Tesla stock, Bitcoin, the bond market, and passive investing. There's no shortage of other predictions. Perhaps that's no surprise with stocks at all-time highs and bond prices at record levels, trends that have helped push up the valuations of many other assets.

If so many assets are potential bubbles, how is anyone supposed to figure out which ones are really dangerous?

The first step is defining the terms of the discussion. John Normand, head of cross asset fundamental strategy for JPMorgan Chase, is contributing to that effort and says market bubbles share five common characteristics. He acknowledges, however, that it's impossible to be totally certain an asset is in a bubble after it bursts - and fails to recover for a long time afterward.

Here are those five qualities and the reasoning behind them.

(1) Extraordinary momentum that lasts

It's a given that an asset has to make a huge gain in price before it could be a bubble. Normand says it's just important that the stock have extraordinary moment that lasts for a very long time - "so over the past five years rather than just the past year," he adds as an example.

A huge price rally might be unsustainable and could reverse itself, but by this definition it's too brief to be a bubble. Its quickness limits the systemic risk that a bubble poses. Normand says that helps rule out the possibility of a bubble in US stocks.

"Equities exhibit above-average valuations for the US (about 1 sigma from the mean) but only moderately strong price momentum when measured over the past five years because one of those years (2014 was flat) and another (2018) a down year," he wrote.

He rules out the possibility of a bubble in developed market bonds for similar reasons. Normand agrees that prices are extremely high, but says it's not a bubble because prices have risen so gradually and overall investor positioning isn't that long.

(2) Extreme valuations - that tend to mean revert

It's not surprising that extreme valuations would be part of the definition of a bubble as well, but the second component is critical here, too. It's not enough that an asset looks expensive based on a particular metric. That metric has to be one with a track record of falling back to a normal level after long rallies.

Normand's examples of those types of measurements include real bond yields, forward P/E ratios, or credit spreads.

(3) High investor positioning

Normand describes this as a difficult characteristic to assess because it's not always easy to get comprehensive data on how different types of investors are positioned. But he says positioning is important regardless, and in some cases it can rule out potential bubbles.

"A market that is rising quickly but from a depressed level is one that probably entails little positioning risk, because the move results from a covering of underweights rather than a build-up of overweights or leverage (German housing, for example)," he said.

(4) High leverage

With extreme prices and momentum established, those stretched qualities are only going to cause market-wide pain if there is enough vulnerability in the form of major household, corporate, or sovereign leverage.

This is one of the most popular choices for a potential bubble today, as very low interest rates have encouraged companies to take on more and more debt, but Normand says he isn't sure.

"An increase in corporate leverage is obvious, but less extreme than that which preceded the dot-com bubble," he wrote.

(5) Belief the trend will endure

Lastly, a real bubble is marked by a belief that new change isn't just a fad, but represents a permanent change that will become a permanent feature of the market. This is an especially difficult thing to evaluate in the moment.

"The problem with bubble detection much less timing mean reversion is that someone's interpretation of unsustainable trend is often someone else's definition of a structural change," Normand said. "The debate is only settled in hindsight ... some markets that were universally pegged as bubbles in previous eras (Gold in the 1970s, Tech stocks in the 1990s, Bitcoin in 2018) found redemption later via new record highs or significant retracements."

Taking all of those factors into account, Normand says he doesn't believe there are bubbles in any of the major global asset classes - though he says the bond markets in China and Russia and the Chinese housing market are probably the riskiest areas today.

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