Investing in Bubbles

Ed Yardeni, the President and Chief Investment Strategist for Yardeni Research, in his March 4th Morning Briefing, quoted Fed Chairman Ben Bernanke on the subject of asset bubbles. Here is Yardeni quoting Bernanke about the role of the Fed relative to bubbles:

In his January 3 speech before the American Economic Association, Mr. Bernanke refused to accept any blame for the housing bubble. He concluded his remarks as follows: “Is there any role for monetary policy in addressing bubbles? Economists have pointed out the practical problems with using monetary policy to pop asset price bubbles, and many of these were illustrated by the recent episode. Although the house price bubble appears obvious in retrospect--all bubbles appear obvious in retrospect--in its earlier stages, economists differed considerably about whether the increase in house prices was sustainable; or, if it was a bubble, whether the bubble was national or confined to a few local markets. Monetary policy is also a blunt tool, and interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established.”

While our Fed Chairman wants to be absolved from blame for the devastating impact of asset and credit bubbles bursting all around us, I can assure you that at Pinnacle we have a crystal clear take on our mission. We attempt to identify asset bubbles, or investment manias, as early as possible and invest in them for the benefit of our clients. We then try to sell them before they burst so our clients avoid the obvious negative consequence of buying and holding an overvalued asset. In fact, by definition, the positive story for asset bubbles and investment manias are known and understood by the huge majority of investors which is why prices get to extremely high levels in the first place. Investing in bubbles is no place for a contrarian or value investor (which is a hat we also wear when appropriate). For us, bubbles represent a great opportunity to earn excess returns, but they should be treated with caution.

Some analysts believe that U.S. Government bonds with their low yields and high prices represent an asset bubble today. Others believe that emerging market stocks or gold may be the next bubble asset class. We will be diligently looking for the next bubble to emerge, as once again, the central bank has pegged interest rates at very low rates and invited speculation in risk assets of all kinds. This is an excellent habitat to be hunting bubbles.

Credit Markets, Liquidity, and Potential Asset Bubbles

Recently, one of the bearish analysts we read every morning alerted us to the fact that credit default swap premiums for government debt in the U.S., U.K., and Japan have been increasing in price lately. As a reminder, a credit default swap (CDS) is a derivative contract that is usually purchased by an owner of a debt security in order to hedge against a default by the debtor. For years we have lived within a system where government debt, particularly in the U.S., was assumed to have zero credit risk since it can not only borrow in the deepest, most liquid market in the world, but can also print money via the printing press should the need arise. However, as these CDS spreads rise, the market is beginning to price in less faith that the large developed countries, including the U.S., are 100% credit worthy.

Reasons for the recent rise in the cost of protecting against default seem quite reasonable, as the “Great Recession” has forced many developed countries to borrow vast sums of money to help patch together the financial system. And while things have worked so far, and the global economy seems to be slowly recovering, the markets are acknowledging that new imbalances are currently building and new risks are rising. Some analysts argue that there is room for debt to rise before public borrowing crowds out the private sector, while others are convinced the public debt binge has us on the precipice of a death spiral for the U.S. dollar.

I think it’s fair to say that the new imbalances and risks are the price we are paying for pulling out all the stops to contain the bleeding within the global financial system. But I also think it’s important to keep things in perspective. Excesses and bubbles can take years to build before they unwind. Even as the risks build, one must respect that the amount of liquidity in the system, combined with very low yield levels, may produce new asset bubbles that run further and longer than most currently anticipate. We will continue to monitor fundamentals and be mindful of current risks in the backdrop. But we will also be watching for areas that may be in the midst of developing into the next financial mania.