3 Key Steps to Recognizing a Bubble

3 Key Steps to Recognizing a Bubble

One would think that after suffering through two devastating bubbles in the last dozen years, American investors should by now be experts at recognizing a bubble. However, it seems we are stubbornly and willfully blind at spotting them, even though the grandest and most deadly of them all is precariously lurking over our economy.

All bubbles are easy to spot if you truly desire to make an objective analysis. That is because they all share the same three basic components. The asset in question must be significantly overpriced and over-owned when compared to historical metrics. In addition, there must also be a substantial increase in its supply.

There are three key steps:

1.      There must be a significant increase in money flows towards the asset in question as was in the dot.com bubble and now is evident into bond funds.

2.      The asset must be over priced compared to historical metrics e.g. home price to income ratio were significantly higher than previous measures during the height of the housing bubble. Bond yields are now at historic lows.

3.      The asset in question must have recently undergone a tremendous increase in its supply. Record amount of debt and deficits.

For example, the housing market clearly met all three of the above metrics beyond any doubt back in the middle of the last decade. Looking at the nominal increase in home prices, as well as the home price to income ratio, one could clearly conclude that those levels were several times greater than historical measures. Also, home ownership rates were at record levels and the rate of new home construction was double the historical average. Therefore, once the demand for real estate ownership became saturated, falling prices were exacerbated by a significant supply glut of inventory. Prices crashed nearly 40% on a nationwide basis because real estate prices became out of reach of the average consumer. And home ownership rates were already at an unsustainable level, which caused the overhanging supply glut to remain in place for years.

Likewise, using the same criteria, one should clearly be able to conclude that the bond market is an epic and unprecedented bubble as well. Bond yields have never been lower in the history of this nation. Inflows to bond funds have been at a record pace for the last several years. Also, the supply of Treasury debt has never been greater; with the U.S. amassing $7 trillion in new debt since the Great Recession began–and is projected to run trillion dollar deficits as far as the eye can see.

If you agree there is a bond bubble, the question is can we protect our portfolios and even profit from its collapse. To answer that question accurately we first have to determine how the bond bubble bursts. The bond market could falter either through the direct actions of the Federal Reserve; or it may come courtesy of the free market.

The outlier scenario is that the Fed exits its $85 billion quantitative easing program and raises rates in an expeditious manner. In this case the central bank would burst its own bubble and would be the catalyst to rapidly rising interest rates. The U.S. dollar would surge and money supply growth rates would crash. Equity, real estate and commodity prices would plunge as the economy enters a deflationary recession/depression. Investors should, in this case, take a short position in Treasuries, commodities, insurance, utility, and consumer discretionary stocks and take a long position in the USD; in the highly unlikely scenario that the Fed wants to recreate the same condition that existed in the fall of 2008.

However, the more likely scenario is that the Fed stays behind the yield curve and maintains its QE program and keeps interest rates near zero percent for many years to come. This scenario would cause investors to take a significantly different strategy than during a Fed-induced bond debacle. In this case, the bond market would eventually crash because of the concern from international investors that the credit, inflation and currency risks of owning U.S. sovereign debt have become far too great.

Therefore, unlike the first case where the central bank caused the dollar’s value to increase, bond yields would be soaring in the context of a crumbling currency. Investors would still want to be short U.S. Treasuries; but would also need to concentrate on long ownership of precious metals, energy and foreign stocks. A short position should be taken in utilities and fixed income sectors like municipal and high yield bonds. Insurance companies that helped banks hedge against interest rate spikes would also suffer greatly.

Investors must admit that eventually interest rates must mean revert. The average interest rate on the Ten-year note is 7% going back to 1970—a far distance than the 2% level seen today. Either the Fed or the free market will eventually take them back where they belong. It would be much better for the nation if Mr. Bernanke began to raise interest rates and cease enabling the federal government to add to its $17 trillion debt that is growing by a trillion dollars each year. If the market does it for him, interest rates will rise much higher than just their long-term averages.

The road back to normalization in the Treasury market will be extremely painful no matter how we get there. Investors need to plan now for the inevitable surge in borrowing costs. Most importantly, that strategy needs the flexibility to prosper during a deflationary or inflationary bond market collapse.