07/08/2014 05:58 pm ET Updated Sep 07, 2014

Hubble Bubble

My daughters would think of "Hubble Bubble" as just two fun words to say, and, admittedly, any sort of bubble is kind of fun, even the investment-related ones -- that is, until they burst (as we know). Staying strictly with an astronomical definition, a Hubble Bubble "is a region that is expanding at a steady but different rate to the rest of the universe, which is also expanding steadily." This reads somewhat familiar when compared to global economic conditions; whereas the U.S. appears to have turned the corner, many other regions in the world (with few exceptions) continue to suffer from subpar growth, structural high unemployment, and massive debt burdens.

Financial markets, contrary to this diverging economic scenario, have "declared victory" over deflationary outcomes; the Great Financial Recession has become a fading memory, and investors are now in a somewhat "bubbly" mood, at least when judging on the basis of asset prices, especially those of stock markets. Then there is this nagging feeling, shared by numerous sophisticated market observers, that the steady expansion of our investable universe may not be aligned with long-term market forces.

The recently published BIS Annual Report by the Bank For International Settlements (aka "the central bank of central banks") summarizes the disconnect quite well. By any historical measure, the economic upswing has disappointed, and whereas the U.S. is furthest advanced, consumers, banks, and crisis-hit economies are still repairing their balance sheets, leading to a reduction of economic activity and output as a result. More importantly, the BIS report highlights a very meaningful opportunity. With stress removed from the financial system, it is time to initiate structural reforms with a focus beyond traditional solutions, thus ending the misallocation of capital and debt as the main engine of economic growth.

Stock market rallies or bull markets, in general, do not trade with a set expiration date, but often end as a result of policy mistakes. In acknowledging the conditional framework of the BIS report, policy makers will have no choice but to initiate meaningful reforms and, in consequence, address the glaring disconnect between economic activity and financial market performance. The BIS finds correctly that "financial markets have been acutely sensitive to monetary policy, both actual and anticipated," with investors, more or less, having accepted a higher level of risk in their portfolio choices as a result.

Edwin Powell Hubble, one of the most recognized observational cosmologists of the 20th century, may not have cared much about the economy (or bubbles in this respect). His deep affection was divided between his work and a unique bond with his cat, Nicolas Copernicus. Hubble named the "black furry" after renaissance man and star gazer, Nicolas Copernicus, who, on the basis of the Copernicus Principle, gave way to a more modern and philosophical interpretation of cosmic concepts; i.e., that any observer should reason as if he were the most standard observer.

If we apply the "most standard view" to current market conditions, setting aside personal aspirations and desired outcomes, we need to recognize that, in cosmology, non-equilibrium systems are commonly transitional. With this in mind, the disconnect between low volatility, level of interest rates, and stock prices will have to adjust to more normalized conditions, or equilibrium. In one way or the other, this necessary transition could lead to losses in bonds and/or equities; the experienced rally of both asset classes concurrently is highly unlikely to continue. Today more than ever, investors are tasked to adhere to the concept of diversified allocation choices, and critical recognition of portfolio risk and reward.