Over recent years, it seems that the only creation of wealth in the U.S. was through the emergence of financial bubbles. I have developed a simple theory on this, which I have called The Champagne Economy. In a Champagne Economy, wealth is created from one bubble to the next. If you unload fast enough, there are huge profits to be made; however it usually presents dire consequences for most investors.
The best way to understand where we currently stand is to look back at where we have come from. Let's start with the Internet bubble; it started in 1994 and lasted seven years. From its peak to its bottom, over $7 trillion of market capitalization disappeared. This unprecedented financial disaster, coupled with the terrorist attacks of 9/11, naturally sent the U.S. economy into recession. The most surprising fact about the 2001 recession was how mild and short it really was.
The Champagne Economy theory would suggest that the only reason the U.S. did not slide into a massive recession in 2001 was the emergence of another bubble, in this case the Housing Bubble. As the Federal Reserve aggressively reduced interest rates, the U.S. consumer saw the value of his house rapidly increasing, giving him access to new capital to feed his consumer demands. It has become a cliché, but an accurate one, that Americans used their homes as ATMs during the boom years.
Gradually, the Housing Bubble morphed into a full-blown Credit Bubble. This Housing/Credit Bubble started around 1997 and lasted for 10 years. When the bubble burst, U.S. household wealth fell by about $16.4 trillion, from its peak in 2007, to when the markets hit bottom in the first quarter of 2009 (source: Federal Reserve). To understand the size of the wealth lost, remember that the U.S. National Debt currently stands at $15.4 trillion.
Now that the Credit Bubble has burst, will a new one replace it or has the Champagne turned flat?
Before I answer this question lets review the three necessary elements to form a bubble, as established by Eric Janzen :
1) The new bubble must already be in existence when the old one pops.
2) The new bubble must benefit from taxation privileges.
3) The new bubble must be extremely popular with the masses.
When I first wrote about the Champagne Economy theory in 2008, I came to the conclusion that there were two future possible bubble candidates: healthcare (remember this was written pre-Obama) and alternative energy. I was wrong. The credit bust transformed consumer debt into bank debt, which in return found its way into sovereign debt. As sovereign debts reach unbearable levels austerity measures will remove the probabilities that we will see important taxation privileges for specific industries going forward. In a world of austerity don't expect too many bubbles ...
It would be easy to conclude that the credit bust was the last chapter of the Champagne Economy. However, we need to look deeper and ask ourselves, if taxation privileges are a relic from the past, how about other forms of government stimulus? Isn't the Federal Reserve's massive intervention and guarantee of low interest rates a much larger impetus then some tax breaks?
And if it is, then isn't the entire bond market in a bubble of it own? It certainly meets our three criteria. The rally in fixed income was obviously well established before the burst of 2008/09, and bonds are also extremely popular with the masses. According to the ICI, within the last two years, and this with 10-year Treasuries yielding 2% or less, taxable bond mutual funds received a net inflow of $366.7 billion while equity mutual funds saw a net outflow of $167 billion.
Is the bond bubble about to pop?
The problem with bubbles is not being able to spot them, but knowing when to cash out. If you haven't participated in the different bubbles of the last 20 years, your portfolio hasn't grow much. If you have participated and crashed with them, then you are worse then when you started. If, however, you participated and pulled out when the sign of a collapse was emerging, you made a killing.
My advice is simple: When there is no longer much value to be extracted from the asset you own, get out and leave some for more greedy investors. When Internet companies popped up with little to no business plan and no profit pre-IPO, the writing was on the wall. When it became obvious that the sum of all the materials in a house were much cheaper then the price you were paying for it, it was time to leave the housing market.
And now that the quality of the asset you own in a fixed-income fund is deteriorating rapidly (especially for sovereigns) and yields are close to 0%, what future expectation of return do you have? Yes, it is possible that we will see 10-year Treasuries going to 1%, however they may also go to 4% or 5%. U.S. sovereign debt presents an asymmetric risk profile, where the possible losses are much higher then the possible profit. The reward in sovereign bonds isn't worth the risk.
I strongly feel that the time to sell most sovereign bonds is now, and if you have to own some, focus on the AAA rating countries such as Canada or Australia. Investors should also keep a close eye on corporate bonds, as the yield paid doesn't compensate for the risk going forward.
For investors wanting to play the collapse of the bond market, one possible idea would be to wait for the next stock correction or the next European sovereign hiccup and buy the ProShares Short 7-10 Year Treasury ETF (NYSEARCA:TBX).
However, the best play in my book for the next 10 years is to go long the U.S. dollar and short the Japanese yen (see previous article on the subject here ). U.S. interest rates will increase in the future, and Japanese interest rates can't. If they do, the country will be bankrupt and therefore Japan, as they did two weeks ago, will continue to print more and more money.
If the U.S. economy continues to ameliorate, you will gain through the interest rate differential between the two countries. If the U.S. economy deteriorates, the Fed may come back to the market with QE3. This would be detrimental to TBX, but shouldn't affect the short USDJPY for much time, as we would expect the Bank of Japan to follow in the Fed's footsteps.
We are all hungover from the excesses of the last 20 years, and the champagne bottle is almost empty. But don't leave the party now, as there is still one last bubble to pop ...
Disclosure: I am long USDJPY