Asset Bubbles: How Do I Love Thee?

Includes: DIA, QQQ, SPY
by: Katy Delay

Before we count the ways, let's define an asset bubble for the sake of discussion. I'm not a professional economist, but I still like to work with well-defined words. So for my purposes here, permit me to clarify my use of three terms:

  • Asset bubble: a nominative market evaluation of an asset that is significantly higher than the asset's real value.
  • An asset's real value: the smoothed real market-value trajectory over time compared to other things of known real value. (See this chart where the Dow's long-term trajectory looks to me like it's around 5.)
  • Thing of known real value: I have picked gold, because everything else is priced in terms of unstable fiat dollars. Please note that in my dictionary, the "price" of gold in dollars is really the "price" of dollars in terms of gold.

So what do we find? The Dow is around 5 on my chart, and it looks like its current trajectory is up somewhat. But you'll notice it never really got to the down territory it went to in our two previous grand recessions in the 1930s and the 1970s. Note the kick-up in 1976 (a pattern I think we are copying) when the then-Fed had a similarly stimulative policy. We're not finished with this recession yet, in my view.

If my hunch is correct, the Dow and the other indices are all in the midst of a kick-up bubble. The same logic applies to the other indices and to real estate, because the artificial propping up of assets has definitely flowed into mortgages and real estate loans.

Even if I can't prove my hypothesis, I "just know" bubbles are happening. Not scientifically, but instinctively. When you start getting those credit card transfer-check offers in the mail again, when the hawkers are back on the radio touting ways to flip real estate, when strangers beg to lend you money for a car at outrageous interest rates in a ZIRP world (the Fed's zero interest rate policy), and when the stock markets are hitting all-time records-again, we're bubbling, even if elites like Fama and Professor Yellen don't think so.

Bubbles have always been with us throughout history. More recently since 2008, I believe the bubbles started with bonds, thanks to the Fed and its QE1. Then they moved into the emerging markets, thanks to QE2. Now they are in real estate and in the various stock markets and IPOs, thanks to QE3. (And never mind that big fat one on the Fed's balance sheet, which is linked to our whopping and very scary national debt. Keep in mind that bubbles are inflated with empty credit, which is simply uncollateralized debt.)

Not being a scientist, I can't find a way to prove this, although someone else probably can. I have looked for such proof, and lacking some, I have found interesting descriptions of the process through which bubbles might easily be created at this very moment. One that caught my eye this weekend is Doug Noland's piece at Prudent Bear. He sees the Fed blowing bubbles through successive transfers from Fed printing press to the bubbling asset classes through what he calls "speculative dynamics."

Here are two of his examples of the process:

As an illustration, follow the trail of outflows from a somewhat less popular 'Total Return Bond Fund' (TRBF). To fund outflows, TRBF sells Treasuries to the Federal Reserve. TRBF then transfers Fed liquidity to exiting investors that then use this 'money' for investment in the now extremely popular 'Total Stock Market Index Fund'. This fund then takes this 'money' that originated with the Fed and bids up stock prices.

Or, how about an example where a hedge fund moves to exit an underperforming emerging bond market. Here the fund is unwinding a leveraged 'carry trade' that involves selling the EM bond and liquidating the EM currency position. With the EM bonds and currency under intense ('hot money' outflow) pressure, the local EM central bank intervenes with currency purchases (sells dollars to buy the local currency). To fund these purchases, the EM central bank sells Treasuries to the Federal Reserve. The central bank then uses Fed liquidity for purchasing currency from the hedge fund, and the hedge fund then has 'money' to rotate into 2013's speculative vehicle of choice - US equities.

See the whole article here.

Nolan also notes:

If Fed officials actually attempted a cost benefit analysis prior to commencing 'QE3', I seriously doubt they contemplated a 40% surge in the broader U.S. stock market.

Out of fairness, I must tell you that some experts say bubbles don't really exist. They believe that the market always determines the proper value of an asset at any given time. (See, e.g., Eugene Fama and his Efficient Market Hypothesis. See also, just for fun, Fama's incredibly naive evaluation of the Fed's QE3 policy in this hilarious YouTubed conversation with Rick Santelli.)

If you've followed my argument so far, then this latest stock market craziness is a kick-up bubble. So when will it burst? It might blow up some more. Or possibly it might deflate sometime around the next few months when the Fed actually announces their first earnest effort to slow down bond purchases.

Or it might wait until the Fed begins to raise its key lending rate, if they ever do. The Fed has been very careful to announce that they will retain ZIRP for an extended period. Why? Because they fear that the crap will hit the fan as soon as they stop, or even slow, the program. (See my earlier post.) If they don't, then I suppose we could get Japanese-style stagnation, or a 1970s style stagflation; but eventually, and not too far out, something's got to give. Maybe it'll be gold breaking out again, i.e. the dollar devaluing again.

Conclusion: How can anyone under these circumstances buy stocks and feel safe? Yet, unbelievably, retail investors are just now getting back into the market … wait a minute, isn't that in itself a sign that this is a bubble?? (You think?)

Maybe we all should just hold onto our gold a bit longer.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long gold-related investments.