This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
The build-up of a stock market bubble is not too difficult to spot; starkly rising asset prices are usually a good starting point. Dramatically increasing debt ratios are a strong hint towards a credit bubble. The Bank for International Settlements has a great framework to spot credit bubbles, and using a similar framework we believe China still poses substantial credit risks at the moment.
The ‘Heiligenberg Index’ is a measure I have devised to help predict both asset and credit bubbles, using a range of indicators put in an equally weighted index. The index has signalled both the 2000 and 2008 bubbles quite well and the index is clearly elevated at the moment.
Last August, I believed it was too soon to call the top, and stock markets are up more than 10% since then. So far so good.
Compared to last year, the Heiligenberg Index has increased, as market volatility is increasing and interest rates are drifting up. While it is clearly getting more difficult to deny markets are getting bubbly, the index is at more or less the same level as in 2014. All in all, like last August, I think it's too early to raise the alarm.
So, it is not the formation of a bubble that is difficult to spot, it’s correctly calling the time of the bubble popping that is the problem. There is no standard playbook for it. There are no maximum levels of asset valuation or debt after which the bubble must burst. In fact, there is no guarantee a bubble will burst at all.
A Bubble in China?
The un-popped bubble in China, which pundits have been warning about for years, is a case in point. We believe it is a credit bubble, waiting to burst. But it is difficult to determine when and there is a remote possibility it will deflate without bursting. Go defensive too early and you miss out on essential returns or pay out too much insurance premium.
The odds are stacked against investors timing a credit crisis. To increase those odds, professional investors spend a lot of research time analysing credit risk. This should help gain a better understanding of transition mechanisms that lead to a crisis i.e. recognise the flapping of a butterfly before it turns into a proper tornado. However, credit problems are more likely to come to the surface when the economic cycle weakens, like in 2007, so a cyclical view remains crucial as well.
In that light, global growth is doing well for now, inflationary pressures are building gradually but not alarmingly and we would expect recession indicators to start flashing red around the end of this year.
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