FInancial Planning: When Bubbles Burst

By Steven C. Merrell

Q I have heard several people on television say that we are in a "bubble economy." They point to the stock market and things like bitcoin and housing prices and say they are "irrefutable evidence" that we are in a bubble. First of all, do you believe it? Second, if we are, what can I do to protect myself?

A You ask the $5.4 trillion question. That's how much the federal government has authorized in stimulus spending since March of last year. To put that in perspective, the entire Federal spending on New Deal programs from 1933 to 1940 was $50 billion. In other words, we have spent 108 times more fighting COVID in one year, than they spent fighting a global economic depression in seven years.

Monetary policy has also been extremely generous. Since March 2020, the Federal Reserve has pushed interest rates to near zero and has pumped trillions of dollars of liquidity into the economy. The complete magnitude of their operations is difficult to measure. However, we know the Fed has been buying U.S. Treasury Bonds at a clip of $80 billion per month plus another $40 billion each month in mortgage-backed securities.

The magnitude of stimulus from fiscal and monetary policy is starting to raise concerns. One of the most vocal critics has been Lawrence Summers who served as Treasury Secretary under Bill Clinton and as the Director of the National Economic Council under Barack Obama. Speaking on Bloomberg television on March 20, Summers said:

"I think this is the least responsible macroeconomic policy we've had in the last 40 years. It's fundamentally driven by intransigence on the Democratic left and intransigence and the completely irresponsible behavior in the whole of the Republican Party. . . . There are more risks at this moment that macroeconomic policy will cause grave risks than I can remember."

Summers then concluded, "I believe there is a one-third chance that inflation will significantly accelerate over the next several years."

To be fair, inflation is a very complicated topic and not all economists agree with Summers. They note that inflation has been subdued for the past 13 years despite dire predictions that quantitative easing during the 2008 financial crisis would lead to surging consumer prices. They note also that current consumer price inflation, as measured by the personal consumption expenditures deflator, is still up only 1.6 percent versus year-ago levels - well below the Fed's 2% target rate.

However, other kinds of inflation can be just as dangerous to unwary investors. For example, we have seen a dramatic run-up in asset prices over the past year. Asset price inflation at its extreme is what we commonly refer to as an economic bubble.

Asset price inflation isn't all bad. Those of us who invest in stocks have enjoyed its benefits for years as have those who own homes or bitcoin or many other types of assets. However, the fact that stimulus isn't slowing down even as the economic activity is accelerating should raise some alarm bells. We have all experienced the unpleasant aftermath when economic bubbles burst.

If you are worried about a stock market bubble, the time to take action is now while the market is strong. Here are three actions you might consider.

1. Review your portfolio allocation to make sure it fits your unique financial situation. You should look at how much money you will likely need to draw from your portfolio in the next couple of years and move that money into a laddered portfolio of short-term bonds. I wrote about this a couple of weeks ago.

2. Review your individual holdings for quality. Bursting bubbles can cause broader economic disruptions which, in turn, cause marginal companies to fail. Shift from weak companies to strong companies.

3. Diversify your risk. Make sure you have many investments spread across several different sectors and industries. For this, I generally prefer index funds. If you are using individual securities, make sure no single holding accounts for more than 4% of your portfolio.

Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to [email protected].