How to Tell That the Economy Is In a Bubble (When No One Else Can)

The policymakers at the Federal Reserve, and at most central banks for that matter, have a horrible track record when it comes to figuring out when an economy is in a bubble. By the time they realize that the bubble has even existed, it has already burst. They end up playing catch-up, reacting to a financial crisis months after it has already gotten underway.

Their policy response isn’t any better either, as every recession is responded to with an ever-larger injection of money into the financial system. Every successive bubble then becomes larger and larger before it bursts, exacerbating the negative effects and drawing out the subsequent recovery.

Right now we find ourselves in the midst of one of the largest bubbles ever, with the Federal Reserve and central banks around the world sitting on top of massively bloated balance sheets thanks to their quantitative easing policies. But while prices for most financial assets may be high, most Americans have nothing to show for the supposed recovery we’ve experienced over the past decade.

Nearly a quarter of American households feel themselves to be in worse financial shape than they were before the last crisis, which is completely understandable. Prices are higher, wages are stagnant, and debt levels are more elevated than pre-2008. When the next bubble bursts, it’s going to make 2008 look like small potatoes.

Investors shouldn’t give up all hope, however. Just because stock prices are elevated and there are no good buys out there doesn’t mean that investors can’t make good returns. They just have to know how to detect a bubble and how to invest during and after a bubble. Thankfully there are three relatively simple signs to look for in order to diagnose when an economy is in a bubble, and we’re starting to see all three right now.

1. Stocks Are Near All-Time Highs

What goes up must come down. It’s often difficult to assess when all-time highs have been reached until months after they’ve come back down. But today we have a unique instance in which stocks have been at or near all-time highs for over a year.

After reaching highs last February, stock markets plunged and floundered throughout the summer before hitting new highs in October. Then they tanked again in late 2018 before recovering in the first quarter of this year. While the S&P 500 has hit new highs recently, the Dow Jones Industrial Average keeps plateauing just short of its all-time highs. That inability to break through those plateaus is an indicator that stock markets are topped out and that the only way forward from here is down.

With such a short bull run (2016-2018) and a plateau since then, it could still be a while before stocks hit rock bottom. Even during the financial crisis, as bad as it was, it took a year and a half for stock markets to go from their all-time highs to their deepest lows. So it very likely will be over a year or more before stock markets bottom out. That gives investors plenty of warning and plenty of time to assess what kinds of alternative assets they want to move their money into in order to safeguard their wealth.

2. Central Banks Are Cutting Interest Rates in a “Strong” Economy

Central banks generally cut interest rates in an attempt to boost the performance of a struggling or stagnant economy. After all, that’s why the Fed decided to cut interest rates to zero during the financial crisis. So why is the Fed even considering a rate cut right now?

The Fed’s target federal funds rate is currently 2.25-2.50%, an incredibly low rate by any historical standard. Yet the Fed is widely expected to cut rates at least once, if not twice, before the end of the year. How does that square with an economy that is supposed to be booming?

Fed Chairman Jay Powell likes to wax on about how strong the economy is. President Trump does the same. But a strong economy is one that can survive on its own, without injections of trillions of dollars of newly-created money.

The reality is that the US economy is on the verge of very severe economic correction. Even the Fed, which states publicly that everything is fine, understands that there is a downturn around the corner. That’s why the Fed is prepared to cut interest rates, in an attempt to keep the economy going for just that little bit longer before the recession rears its ugly head.

There’s political pressure there too, as President Trump doesn’t want to enter the 2020 election cycle with an economy that’s starting to head south. But the historical pattern has always been pretty clear that the Fed’s rate cuts after a series of hikes almost always occur just months before a recession begins. They’re not a cause of the recession but a belated reaction to the recession, and this time around is no different.

3. Relationships Between Asset Prices Are Diverging

Most assets trade in ways that are relatively straight forward and predictable. When stocks do well, gold often doesn’t, and vice versa. But now we’re starting to see divergence of a kind that we haven’t seen in a while.

Even with stocks pushing back towards all-time highs, gold is doing really well, pushing well above $1,400 per ounce in the aftermath of last week’s FOMC meeting. That relationship means that the smart money is moving into gold, while stock markets are now the haven of those late to the party and hoping that stocks will resume their upward movement. But they’ll be left holding the bag.

The same factors that motivated stock market investors in 2016 and 2017 are starting to motivate gold investors in 2019. Now that they realize that stock markets are going to drop and gold markets are going to gain as a result, they understand that gold is set for a repeat of its 2007-2011 run.

Back then gold gained 25% while stock markets lost over 50%, then continued to gain for several more years. Another run like that today could easily see gold over $2,000 within a couple of years, and that’s not even a far-fetched scenario.

Investors who had the foresight to lock in their stock gains and move their assets into gold are reaping the rewards right now. But it’s not too late for investors to protect their wealth with gold. With gold set to break out this year, the time is right to get into gold before the next crisis rears its ugly head.