Bubble, bubble toil and trouble

Julian Robertson in an interview today speaks about a bubble being blown by the Fed. Like everyone else, he doesn't know when it is going to pop, but he knows it is going to pop.

A bubble is a serially correlated error on a mass scale perpetrated by a blinded marketplace. Herding if you will.

Which leads me to ask myself the question (which I ask periodically), where do I see bubble characteristics?

What are the characteristics to begin with? Substantial increase in leverage and laxity of constraints wrt to access to cheap capital - leads to misallocation of resources and increase in valuation. Unsustainable and undefensible increase in valuation. Area attracts a large flow of new capital. Industry/sector/country is systematically important due to its size and spreading effects throughout the economy. 

In financials? No. Capital has been rebuilt. Lending standards have improved.

In energy? No. The bubble, and there was one in shale, has been popped already. There are dead men walking, but no systematic risk impact on the market.

In technology? No. Not if you look at the balance sheets and valuation of the majors (AAPL, MSFT, SAP, ORCL, QCOM, etc.). I definitely see a bubble in next generation tech (TSLA, NOW, CRM, NFLX, N, etc.) but even many of those have seen their valuations shrink as they grow and market price have come off the boil.

In materials? No. If anything, the bubble has been popped already in that space. Just look at gold, copper, coal, etc.

In industrials? No. Valuation is stretched, but not out of this world.

In consumer discretionary? No.

In healthcare? Don't know. It has had a huge run. Definitely biotech side of sector. But biotech is not a systematically important part of the economy.

In utilties? No.

Dollar. No. That is good for everyone else and the US can handle it. Although if it were to throw the US into recession then that would be bad for everyone. 

In bonds? Possibly. Massive move to bonds over last six years. But bonds don't really pose a systematic risk unless the underlying defaults. And most of the new debt is govt.

In China? Possibly. But I've been calling that one for years, so I have zero credibility. Like Julian Robertson I believe there is a bubble (in China), I just don't know when it will burst.

China looks to me as the best potential for a "bubble." The massive run in the Chinese stock market may be a sign of things getting out of control, or it may simply be a sign of a soft landing.

Or, it could be the whole global system which has increased its leverage significantly in the last six years and susceptible to a rise in interest rates.

Perhaps that is it. Interest rate risk is the largest risk out there.

What Rate of Return Can You Reasonably Expect by Peter Bernstein

Latest FAJ looks at retirement issues on its 70th anniversary.

Peter Bernstein took a look at stock and bond returns over a two hundred year period to try and figure out whether there was a "basic return" that could be expected for each asset class. He normalized his analysis to take account of starting and ending multiples and yields to ascertain what the return was over those periods.

His basic conclusion was that stock returns exhibited a mean nominal basic return of 9.6% with a standard deviation of 1.6% and some mean reversion elements.

With regard to bonds, the outcome was much less conclusive.  The mean nominal basic bond return came to 4.9% with a standard deviation of 2.3%, but there a wide band of uncertainty associated with the data and in fact he concluded we could have no confidence in expecting the nominal basic return because inflation would surprisingly pop up (investors were slow to respond to changing inflation environments) and there was no pattern to the returns (little credence can be attached to what anybody has to say about what the real what the real long term rate of interest should be, has been, or will be in the future over the long run). About the only thing we can say for bond holders is they can make con judgments about future returns beyond the duration of the particular instrument they happen to hold at any given moment.


Bottom-line: long run equity returns were more predictable than long run bond returns (with even greater application for real returns). With equities one can at least conjecture whether the market is high or low (based on recent returns), with the bond market there is no such opportunity.

He concludes that stocks are fundamentally less risky than bonds, not only because their returns have been consistently higher than those of bonds over the long run but also because less uncertainty surrounds the long term return investors can expect on the basis of past history.

Balance

I don't see too many imbalances in the system. Equities appear fairly valued. The economy appears to be getting back on track. I guess bonds are the obvious area of imbalance, both in terms of the amount of debt outstanding and the price paid for that debt.

Of course, balance is predicated upon confidence and if confidence evaporates, then balance disappears along with it (or at least adjusts to a lower equilibrium).

The accumulation of overweight (aka as imbalance) is greatest in the sovereign area. But so long as sovereign's can maintain confidence, they can continue to accumulate liabilities.

Look for market reverberations (like in the summer of 2007) for signs of disequilibrium. Japan is the most obvious candidate.

Until then, party like its 1999.

Why are bond yields so low?

There are myriad reasons why bond yields are so low. I have found it useful to list them so that I have a framework for seeing the various parts and gauging how they change over time. Here is why bond yields are so low:

(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.

Are Bond Economists Better Than Equity Economists?

Q. Is there a difference between bond economists and equity economists?
Ans. I doubt it. At least I suspect that would be the case if you did an empirical study of the question.

Having said that, why do I feel that bond economists tend to be more pessimistic and equity economists tend to be more optimistic?

Much, no doubt, has to do with the markets they are speaking to. We all want to hear, what we want to hear.