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Bursting the ‘Bubble’ Bubble

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Tuesday, 17 May 2011 07:44 AM Current | Bio | Archive

“I can calculate the motion of heavenly bodies, but not the madness of people.”

All investors know the story: Isaac Newton lost substantial sums of money when the South Sea Bubble burst in the late 18th century.

What most investors don’t remember is that Newton was an early investor in the company. He bought in when nobody cared for the stock. Newton then assumed there was a top forming when all his friends started buying in, so he sold out.

But shares in the South Sea Company kept rising. His friends were getting wealthy. Newton got frustrated sitting in cash … so he went all-in. That’s when he lost big.

Newton let his emotions get the better of him. He saw people making easy money and joined the crowd. He ignored the inevitable tug of financial gravity.

Today, bubbles are everywhere, apparently. Depending on who you talk to, the list includes precious metals, Chinese Internet stocks, social-networking companies, and even things that can’t be traded, like the costs of higher education.

While many of these areas are overvalued, it’s tough to call them so overpriced as to be in bubble territory.

Why? Mostly because there’s still some rational justification for current prices. Precious metals represent a real store of value. Chinese stocks and social-networking companies have huge growth potential, so they compel high valuation. A college education increases one’s earnings potential for life.

One of the key characteristics of bubbles is that market participants ignore fundamentals and start joining in because everyone else is doing it. Even if some recognize it as a bubble, they still put more money in, because that’s where the crowd is going.

As Charles Prince, then-CEO of Citigroup, infamously said in 2007: “As long as the music is playing, you’ve got to get up and dance.”

Let’s face facts: There are many pockets of overvaluation. There always are. But one area in particular stands out as a potential bubble right now: U.S. Treasurys.

For the past 30 years, interest rates have been declining, offering investors in these securities less potential upside. China continues to slowly unwind its massive Treasury position, and Japan could liquidate in coming months to fund earthquake-relief efforts.

There have already been a few issuances of Treasurys (namely TIPS) with a negative yield. That means investors are taking a loss to park their cash with the government! If this trend continues beyond TIPS and into regular T-bills, we may soon reach a tipping point.

Some think we’re close. Bill Gross of Pimco, who runs the world’s largest bond fund, has cut all his Treasury holdings and has signaled that he’s waiting for higher interest rates (which means lower prices on bonds).

Warren Buffett laments that there’s no better alternative to cash than T-bills … although he continues to expand investments into foreign currencies.

Alas, even if there is a bubble in Treasurys, different rules apply. In the Treasury market, the Fed stands as a buyer of last — and likely soon to be first — resort.

So instead of an outright popping of the bubble, a more likely outcome is the scenario playing out in Japan: Their government bonds have had ultra-low rates for decades, while their economy has stagnated. All because rates were kept too low, and everyone got up and danced too long.

Madness indeed.

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AndrewPacker
I can calculate the motion of heavenly bodies, but not the madness of people. All investors know the story: Isaac Newton lost substantial sums of money when the South Sea Bubble burst in the late 18th century. What most investors don t remember is that Newton was an...
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2011-44-17
Tuesday, 17 May 2011 07:44 AM
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