"Looking for Bubbles"

Sydney M. Williams

Thought of the Day

“Looking for Bubbles”

July 21, 2010

On December 5, 1996, then Federal Reserve Chairman Alan Greenspan spoke at the American Enterprise Institute: “How do we know when irrational exuberance has unduly escalated asset values which then become the subject of unexpected and prolonged contractions as they have in Japan over the past decade.” He then spoke of the fact that the stock market crash in 1987 had generated few economic consequences. However, he concluded: “But we should not underestimate or become complacent about the complexity of the interaction between asset markets and the economy.”

The next day the S&P 500 closed down 4.78 points at 739.60, but a year later the same index was 33% higher and it finally peaked more than three years later on March 24, 2000 at 1527.46. Stocks peaked and in the subsequent decline six trillion dollars were lost, but again, like the late 1980s, the economic impact was modest. In part, that was due to the fact that, generally, stocks were not highly leveraged. Even the attack on 9/11, in the midst of a bear market, did not catapult the economy into a recession longer than two quarters.

It is curious, in retrospect, that the collapse of Long Term Capital in 1998 did not leave a more lasting imprint on bankers regarding the risks of leverage. Perhaps the answer lies in its quick containment, so that only a few were affected. The banks that helped in the rescue learned no lesson; they persisted in the pursuit of levered profits; so now, ten years later, many have disappeared into Never-Never Land.

It was our complacency, brought about by the lack of economic impact following the sharp stock market correction in 1987, the Asian crises of 1997 and the collapse of Long Term Capital, that set the stage for the housing bubble of 2002-2006. The mythical story of the boy who cried wolf proved prescient. When banks, already heavily leveraged, were left holding the bag after highly mortgaged house prices collapsed, the economy was hit by a series of round-houses. Politicians, who were importantly responsible for the devastation, ducked for cover and quickly blamed institutions for fomenting the bubble. We are now living through a bubble and the consequences of its collapse, so a bubble is no longer something we read about in dusty histories. It is, then, unsurprising that commentators on Wall Street and in the Press see bubbles everywhere.

Bubbles are not new to our lexicon. The South Sea Bubble, 290 years ago, is known by that name. A bubble can be defined as the price of an asset that is trading, typically in high volumes, at a considerable variance to its intrinsic or historic value. Bubbles are usually associated with leverage, but they are rare.

It is Treasuries, today, that most commonly are being dinged with the label, “bubble”. But not every over-priced asset becomes a bubble. In fact most do not. Regardless, bonds and especially Treasuries, as the ultimate “safe” vehicle, have done very well. Their rise has not gone unnoticed. Over the past ten years, as the S&P 500 Index slumped 24%, the yield on the Ten-Year declined from just over 6% to just under 3%, indicating that Treasuries were the place to be. At the end of June, 2007, just prior to the housing bubbles’ appearance, the yield on the Ten-Year was just over 5%. Even today, following an incredible 83% return to stocks from bottom to top, the fifty-two week total return to stocks is a mere 12.5%. That can be compared to a 24.4% for high yield bonds, the most equity-like debt instruments. Jeremy Grantham, in his July 2010 quarterly letter, writes: “fixed income is desperately unappealing.”

Wall Street commentators love labels; they dramatize our condition; thus the “new normal” of PIMCO and Jeremy Grantham’s “seven years”. “Bubbles”, as a label, have become ubiquitous. Over-priced assets are common and, fortunately, very few become bubbles. Over-priced assets always correct and when they do those that are long, suffer; those who are short make money. Bubbles, in contrast, are rare. They are often debt induced. Their collapse has enormous consequences. Extended, over-priced assets when they fall are no fun and the resulting bear markets cost investors trillions of dollars and can cause a few to lose everything. When bubbles implode, as happened in Holland in 1637, in London in 1720, in New York in 1929 and most recently across vast swaths of the United States in 2008, chaos ensues.

In comparison to bonds, stocks seem reasonably priced; though I worry about the effects of a contracting consumer on economic growth and the impact of a government swollen with bureaucrats and debt. But, I note that many historic skeptics have become more positive on certain equities: people like Jim Grant of Grant’s Newsletter, Bill Gross of PIMCO and even, though reluctantly, Jeremy Grantham of GMO.

Nobody can predict how high prices will go when they soar, or how low they will go when they fall. To one who is expecting deflation and notes that the yield on the Two-Year has fallen from 1.01% at the end of March to 0.57% today, going further out the yield curve may make sense. But the further out the curve you go, the more risk you assume. Treasuries seem extended to me, but I don’t believe they fit the definition of a bubble.