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© 2017 by Coastwise Capital Group, LLC 

Bubble Bubble Toil and Trouble

July 22, 2016

In 1996, then Fed Chairman Greenspan warned of a bubble in the equity markets, specifically US growth stocks.  As not even the individual with more knowledge than anyone in the world about the US economy can successfully time markets, Greenspan got the bubble call right, only 3 years early.  Once the tech bubble ultimately burst in early 2000, trillions of dollars of net worth vanished in months.

 

Today (and similar to the late 1990s when premature warnings were made by some prominent value investors) many intelligent financial types have been warning of a bubble in bonds around the world.  These prognostications started even prior to the more recent trillions of dollars ‘invested’ in negative interest rate bonds globally.  It is an unprecedented financial event in our history. 

 

Back in the late 1990s even professional money managers often justified buying companies at 50X plus P/E ratios (well above valuations those otherwise quality companies like CSCO, etc. had ever traded at) by stating that other companies like JNPR were trading at even higher multiples, thus on a relative basis a stock trading at 50X was certainly a bargain compared to one trading at 85X.  The same is being said of US treasuries which have been hovering around historical low interest rates (and thus high valuations) as of late.  Compared to having to pay for the privilege of loaning your money to someone (AKA negative interest rates), earning 1.4% per year for the next 10 years on a US treasury is the deal of the decade….or so it goes.  The relative value argument is a dangerous one. Sure, compared to someone 5’ 1”, a 5’ 6” guy is relatively tall, but that does not mean he could succeed in the NBA against a bunch of 6’ 6”+ monsters.

 

As in the late 1990s, when there were pockets of the stock market that were reasonably priced (e.g. small cap value stocks) and thus performed well over the subsequent decade (whereas US growth stocks had returns of basically 0% on a real basis for a 10 year run), there are segments of the bond market which are reasonably valued - and others that will very likely subject their owners to trillions of dollars in losses in the years to come.  Knowing what you own will be key to principal loss avoidance.

 

Despite warnings from some lone voices, bubbles are hard to spot – or more accurately easy to ignore - as the profits seems easy and never ending.  Then, interestingly, when they finally do pop, most investors look at their losses with surprise, shock and horror.  2013 gave us a glimpse of the carnage that could ensue in the bond market as the 10 year rate climbed from around 1.8% in late 2012 to nearly 3% by the end of 2013.  That rise in rates lead to double digit (and trillions of dollars) losses in the US treasury market.  Imagine the blood bath rising interest rates from negative to even slightly positive will have for bond holders around the world. As bonds are often held in mutual funds, many bond investors don’t even know what they own – just as stock investors in the late 1990s simply sent all their spare cash to large cap growth mutual funds who in turn poured that money into massively overpriced stocks hoping upon hope that they could one day sell something very expensive today at an even more expensive price down the line.  As is always the case, the music eventually stopped.

 

Traditional asset allocation models of 60% stocks/40% bonds will be tested mightily in the years to come.  To be sure, bonds still have a place in accounts of those nearing or in retirement.  However, the easy picking days (which were actually about three decades long from the early 1980s when interest rates were double digits until more recently as they approached 0%) are long gone.  Thus working with an investment professional to make sure you have the right asset allocation as well prudent holdings within each asset class is of paramount importance.  Unlike the late 1980s when the number of financial products was limited, today there are literally tens of thousands of bond oriented mutual funds, exchange traded funds, closed end funds – many employing leverage which could exacerbate losses in a rising interest rate environment – to choose from, making matters even more confusing and in many cases financially dangerous.

 

Excuse the pun, but it will be a very interesting next 10 years when it comes to bonds.

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