If It Quacks Like a Bubble…

Every instance of financial speculation today is termed a “bubble”, but true financial bubbles are rarer than most investors believe.

Certainly, bubbles include speculation, but the difference between bubbles and mere speculative periods is that bubbles go beyond the financial markets and pervade society.

As we’ve highlighted in past Insights, there are five defining characteristics beyond speculation that are common to historical financial bubbles:1

1. Increased use of leverage.

2. Increased liquidity.

3. Democratization of the market.

4. Record new issues.

5. Record turnover.

These characteristics seem to be spreading in several markets these days. The technology sector, venture capital, private equity, and distressed debt all show several of these characteristics. Their performance comparisons to other markets are getting extreme and, as in most bubbles, investors’ enthusiasm for the asset classes is growing as those performance disparities get wider. Bubbles tend to significantly hurt the performance of contrarian investors, and this cycle has fit that pattern.

We thought it worthwhile to highlight some of these significant disparities.

Corporate leverage

Many observers have pointed out that the US corporate sector’s leverage ratios have increased significantly. Chart 1 shows that public company leverage has indeed increased but does not look dire relative to history. Individual sectors have increased leverage (i.e., Consumer Staples, Health Care, and Technology), but public equity leverage ratios in general still look conservative relative to history. One should have expected leverage ratios to increase as interest rates fell because companies simply refinanced and expanded debt levels while keeping interest payments at similar levels.

Leverage ratios among public companies have increased, but leverage ratios among private companies has ballooned. According to Empirical Research Partners, Debt-to EBITDA for private companies is more than double that of the S&P 500® (see Chart 2). Investors often point to the higher returns associated with private companies but fail to mention those companies tend to be more cyclical and more highly levered than is the overall public market.