Anatomy of a Bubble

September 3, 2010by Hoy Grimm0

In recent history, we have been through asset price bubbles in dot-com stocks (1995-2000), real estate (2001-2005) and oil (2003-2008). Each of these situations exhibited similar characteristics. They started innocuously, attracted massive capital inflows, ascended higher than anyone imagined, lasted longer than anyone expected and by the end they mercilessly trapped investors regardless of their acumen. 

Warning signs are gathering that the U.S. bond market may be the next bubble to burst. Even while stock investments are experiencing net redemptions, investment companies are collecting record inflows into Bonds. In the face of strong demand, Treasury yields are at historic lows which correspond to historically high bond prices.

A recent Bloomberg article calculated that more money is flowing into bonds right now than flowed into dot-com stocks in 2000. These sudden, massive cash inflows complicate the long-term fundamentals of these markets.

Much of the bond market’s current appeal lies not in the high yields, but in the relative lack of desire for the alternatives. Stocks are trading sideways as forecasters are debating whether our economy will continue to improve or descend back into recession. In the face of such economic uncertainty, stock investors are leery of taking too much risk with the few shekels they have left after the recession. At 1.5 percent or less, conservative investors who normally keep their money in the bank are not making enough to stay put. Real estate investors still are trying to sell property and de-leverage, so they can stave off bankruptcy. It is impossible to escape the non-stop barrage of advertisements to buy gold. Fortunately, investors are leery of buying into a commodity that does not pay any interest, especially after it has nearly tripled in the past five years. In this environment, bonds are winning by default. They seem like the least bad choice for investors to get paid. For bond investors, current headlines could not be any better.  

 
So, is this truly a bubble that will leave investors with regret or just the “new normal” that some commentators are saying we should expect? Is inflation gone? Are bond yields going to stay low as our government grows to become half or more of our economy like some of our European counterparts? Will bond investors have time to clip a few more coupons before heading to the exits? I do not know the answer to these questions, and to be honest no one else does either. I do know what will happen if bond investors get the answers wrong. Bubbles can be characterized by an almost hypnotic trance that even sensible investors can fall into the trap. They always think they will have time to get out, but they seldom do.

For our part as investment professionals, we are being prudent. We have reduced our client’s exposure to long-term, fixed-rate bonds. We didn’t overstay our welcome. We probably left the party early. It might get really exciting in the wee hours to come, but we will not have a hangover when the sun (and inflation) rises. It is easy to spout axioms like “sell when the news is good; buy when the news is bad.” Through humility, successful investors put these words into action.    

Hoy Grimm

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