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Booms and busts in markets are as old as time. Since the pandemic and its subsequent recovery began, there has been broad agreement among market observers and economists that we are in a boom cycle for most risk assets. In fact, the valuations in most asset classes currently far exceed their pre-pandemic levels. In many ways, this is to be expected: Investors are underwriting a sharp recovery-related growth in future cash flows from these assets and discounting them back at prevailing lower interest rates. In November 2020, the Federal Reserve stated, “The elevated levels of asset prices in various markets likely reflect the low level of Treasury yields, and measures of the compensation for risk appear roughly aligned with historical norms” (Board of Governors of the Federal Reserve System 2020). As an example, in the corporate bond markets, investors value bonds based on their interest rate risk spread over risk-free rates, which are currently at or near record low levels. Because these rates have remained low and the probability of repayment on these bonds has increased in line with a recovering economy, it is reasonable to expect that corporate bond prices will trend higher.
An environment in which risk-free rates hover close to zero, however, also permeates investor psychology. Faced with meager returns at the low end of the risk spectrum, many investors conclude that there is no alternative but to move higher in the risk curve than they have historically, causing riskier assets to trade higher relative to low-risk assets. Furthermore, the boom has created extraordinary investment returns for those who moved into higher-risk assets quickly after these markets bottomed out in early 2020, creating a “fear of missing out” for those who have elected to pursue more defensive investment strategies. For example, high returns in so-called meme stocks have rewarded those investors who have thrown caution to the wind. In a recent op-ed, economist Mohamed El-Erian (2021) wrote that “record loose financial conditions have encouraged and enabled excessive and, in some instances, irresponsible risk-taking.” Certainly past bubbles, including the Japan bubble of the 1980s and the real estate bubble of the late 2000s, have been caused, in part, by monetary regimes that are similar to the one we are in now (see Aliber...