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The Bubble Debate

The Bubble Debate

It is only fitting that I write this post on eighth anniversary on the day Lehman Brothers filed for the biggest bankruptcy in the history of our great nation. It is also fitting that it comes on the precipice of the Federal Open Market Committee (FOMC) meeting on September 16th-17th which could see them raise the federal funds rates for the first time since December 16, 2008. The Fed Funds rate, is the interbank rate, at which depository institutions, banks and credit unions, lend balances to each other overnight[1]. This is the benchmark rate for savings accounts, bonds, treasuries, mortgages, etc. The Fed dual mandate is to maintain full employment, which, depending on who you ask, is somewhere between 5.0 and 5.2 percent. As of the last jobless numbers came out for August 2015, the unemployment rate was 5.1 percent, according to the U.S. Bureau of Labor Statistics[2]. The second mandate of the Federal Reserve is to keep inflation at the rate of 2%, of which we are currently at roughly 1.62%[3], with August numbers set to be released on September 16th.

The way the Fed mandates these numbers is through monetary policy. They do this by either cutting or upping the reserves banks need to keep on hand and by raising or lowering the Fed Funds Rate, which is the big debate that you have seen and heard for the past year now. The Fed Funds rate is currently at 0.00-0.25 and has been this way since December 16, 2008. What has this meant for the market? It has meant companies borrowing (in the form of loans and/or issuing corporate bonds) at extremely low rates to add on more debt to their balance sheets. It has also meant investors chasing yield in the stock market. AAA rated bonds were not paying as much since the benchmark rates are so low so investors were investing heavily in the market and increasing demand, which leads to higher prices. Investors were also chasing yield in high yield bonds, which are the riskiest of assets to invest in. This has led to high prices in the bond market as well.

Some companies have used this cheap financing to buyback shares of its stock. What does this mean for investors? A company's earnings are reported each quarter as mandated by the Securities and Exchanges Commission, of which a number is flashed on a financial news network that pools analysts at financial firms to predict how a firm is doing. These numbers are referred to as Earnings per Share or EPS. This number is calculated by taking the net income (income less expenses) and dividing it by its total shares outstanding in the market. If a firm is buying back shares, it is thereby decreasing the numerator to inflate its earnings, which can be deceiving for the average investor. Firms do this and proclaim they are "returning money to its shareholders". However, this is just the politically correct response. A firm should only buy back its stock if it has healthy free cash flow (if you want to see what healthy free cash flow looks like please see Gilead's financials). If a firm wants to pay money back to its shareholders they should raise their dividend yield rather than buyback stock, under the assumption of course that it has healthy free cash flow and high dividend yield already.

Why are we on a precipice of a bubble? I have always used two key indicators when looking at the market. The first, is an indicator used by, in my mind, the single most revered and brilliant investing mind we have and will ever encounter, Warren Buffet. The Warren Buffet indicator measures the Market Value of Corporate Equities (this is the price per share times the shares outstanding for each corporation) divided by the Gross Domestic Product from the last quarter. This measures investor sentiment for all stocks and their value as compared to the actual spending that is measured in the Gross Domestic Product. As you can see in the chart below, as of July 2015, we were greater than two standard deviations above the mean. This is greater than where we were during the Great Recession, which was an entirely different kind of bubble. However, we are eerily close to the Dot Com bubble where stock prices were overinflated.

[4]

The second indicator that I use is by another world renowned financial mind and Nobel Laureate in Robert Schiller and that is the Shiller CAPE Ratio. This measures the cyclically adjusted price-to-earnings ratio, which is taking into account inflation-adjusted earnings over a 10-year rolling period.[5] As of this post, we are currently at 25.26. Now at the Dot Com bubble we were operating at a level of 44.19.

[6]

What is an investor to do? The answer is…nothing. For most of these readers, you are most likely just putting money into your 401K pre-tax and allocating it as you see fit. This makes you a passive investor. And that is fine. Warren Buffet has always championed putting your money into a low cost index fund and it will grow over time. Personally, I would rather put it in an Exchange Traded Fund that tracks an index and watch it grow as well. ETFs have become more and more popular since they were first introduced to the market in 1993. They offer investors the opportunity to invest in indexes and are cheaper than open-ended mutual funds. These types of mutual funds have more expenses and have to raise cash in the event an investor wants to redeem its shares. That means raising cash by selling shares at sometimes inopportune prices. ETFs trade like regular shares of a stock just like an Apple.

Now, if you're an active investor, someone who actively manages their Roth IRA, there are certain safeguards you can take against an impending Fed Rate hike and a market bubble. First, if you believe the Fed Rate hike will affect stocks and that the market has not already priced it in, you can buy a low cost ETF that invests in short duration bonds. What are short duration bonds? A bond's duration simply measures the breakeven point to when an investor can expect to receive his or her money back from their initial investment. Since bond prices are inversely correlated to interest rate direction, which means bond prices will fall as rates rise. Another way to invest against an impending rate hike is to invest in well managed companies that have little to no floating rate debt on their balance sheet. Floating rate debt carries issuer risk. What does this mean? As interest rates rise, so do the rates on the bonds since the benchmark rates are moving up as well. Finally, if you believe we are in a bubble, you can buy a LEAP call option on the VIX, which measures the volatility in the market. You can also hedge your portfolio's position by investing in an inverse S&P index.

Disclaimer: This is just one man's opinion


[1] apps.newyorkfed.org/markets/autorates/fe...

[2] www.bls.gov/news.release/pdf/empsit.pdf

[3] inflationdata.com/Inflation/Inflation_Ra...

[4] www.advisorperspectives.com/dshort/updat...

[5] www.businessinsider.com/robert-shiller-s...

[6] www.businessinsider.com/robert-shiller-s...

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.