The Bubble Report: August Edition
World financial history has been characterized by a series of periodic manias. There have been more than two dozen key manic events during the past several centuries (and that only includes those formally recorded—there have been others and for much further back than that, based on anecdotal accounts). Often, bubbles begin with a rational concept, such as high-growth new technologies/industries, real estate in a new area, or some other new/unique asset that suddenly becomes popular (a key example being Holland’s tulip bulb mania of the 1600’s—when plants briefly turned into valuable financial property). Bubbles have also had a tendency to begin as an unintended byproduct of other conditions or policies, such as newfound levels of discretionary wealth or easy borrowing conditions.
Bubbles are remarkably easy to see in hindsight but can be difficult to discern while in progress. They are characterized by several factors and you’ll note many of them are not economic-oriented at all, but are more closely linked to tendencies in human behavior. A few of these include: herd mentality (need to be accepted socially by others, to follow what our neighbors are doing and think how they think, as well as the desire to avoid being “left behind”); extrapolation (tendency to take current conditions, such as rising prices on a chart, and assume that same pattern trajectory will go on indefinitely); confirmation bias (listening only to information that confirms one’s views, rather than information to that opposes them); and situational uniqueness (that’s a term we just came up with since the condition is a combination of several others—but implies a dramatic “new normal,” where conditions that would have been bubble-like in the past are now very different, are now a “rational” idea—so, consequentially not a bubble at all).
We’re sure many of these sound familiar when we look back at recent manias, such as internet stocks in the late 1990’s and residential housing through the 2000’s. Rationale used just a few years ago was that we have somehow evolved beyond being prone to bubbles in our basic nature. That nature is the interplay between fear and greed, of course.
If you strip any market down to its essence—no matter the asset or the situation—you’ll find a network of competing buyers and sellers bargaining for the best price. This is true whether you are dealing with homes, stock shares or bushels of wheat. In the final stages of a bubble, the asset in question has become more and more popular, and interest eventually deepens and broadens to all levels of society. This addition of more and more buying demand continues to move prices higher and higher as more buyers convince themselves of an asset’s underlying “value” and how even higher prices (or implausibility of lower prices) in the future are inevitable. This is known as the “greater fool” theory at work, which is the notion that there’s always a hypothetical buyer out in the horizon when you’re ready to sell at a higher price.
In modern times, TV and online media has served to act as an accelerant, through commentary and advertisements—which both serve to “vindicate” the rationale for an asset’s value. Of course, many of these same commentators seem to be peers of each other, and tend to listen to and reinforce each other. An anecdote attributed to JFK’s dad, Joe Kennedy, Sr., back in the late 1920’s, was that he knew a crash was inevitable the day he began getting stock tips from a shoeshine boy. This is indicative of classic bubble behavior, similar to when we saw lower-wage workers qualifying for no-doc mortgages on second and third homes with no money down.
Fast forward to present. Lately, we’ve been asked if gold/precious metals and Treasury bonds are in bubble territory. Of course, that’s difficult to answer at this point, but we can look to market behavior and sentiment as a guide. Both investments have been strong and consistent for several years, which has contributed to their popularity. In the case of precious metals, it’s rare lately to see a financial website without references or advertisements featuring pictures of shiny gold or silver bars. It is also a tangible asset, so people feel like they own “something”—also appealing when less tangible assets are mistrusted. In fact, often when we’re in conversation with the non-financial public, gold and “investments that don’t have any risk of losing money ‘when the world comes to an end’ ” are among the first things we’re asked about. Interestingly, the local news in our area last week described an alleged gold coin investment fraud perpetrated by an advisor/radio host—fraud has tended to appear during the latter stages of bubbles as investors’ fear of being “left out” finally overcomes normal skepticism.
Using the criteria mentioned, it might seem gold is acting more “bubble-like” than Treasury bonds, but, if a person were to include all available “safe” assets—such as savings accounts, low-yielding CD’s and other cash- and low-risk vehicles—the entire group has experienced rampant popularity. Both started as viable ideas: gold as a classic portfolio hedge against inflation and global geopolitical/currency uncertainty; and “safe” assets as, well, a lower yield in exchange for those with very short timeframes or demanding lower risk and/or complete principal protection. When we think about the sentiment behind these assets together, it appears we may have a potential bubble in “safety.”
Perhaps where we are in the bubble status is, again, unanswerable. But it does leave us with the question of who’s left to buy “safety” when safety gets too expensive (whether that’s measured by a dollar price per ounce or an extraordinarily low and uncompetitive interest rate). Another way to look at this is: if everyone has accepted and jumped on the bandwagon of widespread economic collapse, who’s left to fear economic collapse? That’s the question at the margin that may end up providing the catalyst for a re-emergence from fear into realizing “we’ve been through this before and made it out… we’ll do it again.”
It also brings up the concept of an “anti-bubble,” referring to an asset so unpopular that even good news can’t motivate buyers. Imagine the behaviors noted above from a negative mindset: herd mentality (an ignored asset no one wants to brag about owning—those who do venture in tend to be the “lone rangers”/contrarians); extrapolation (projecting assumed continued high volatility and bearish prospects for an asset with strong long-term performance); confirmation bias (focusing attention on news that points to catastrophic outcomes, while discounting any positive signs—forgetting that a mix of the two is more typical); and situational uniqueness (not realizing that the world is constantly changing, is often in flux, but problems aren’t really “new” and tend to be overcome with time).
Based on investor outflows from equities and into fixed income and other assets, it appears that concepts like global growth and risk assets like stocks may be in the “anti-bubble” zone. Retail investor cash flows (with a herding tendency) seem to confirm this. Investors withdrew an estimated $23.5 billion from US domestic equity mutual funds in the week ended August 10th—the largest weekly outflow since October 2008. In total, U.S. domestic equity funds have recorded $56 billion in net outflows this quarter so far, compared to $25 billion in the 2nd Quarter.
Food for thought, anyway, for the contrary thinkers out there.
Economic News
The Richmond Fed Survey of manufacturing activity showed a bit more economic weakness than expected for August. It seems that Richmond (which covers the Mid-Atlantic States, DC and the Carolinas) isn’t always watched particularly closely, but now that growth rates have fallen, all reports are seeing greater scrutiny.
New home sales for July declined a bit more than expected, by -0.7% to a 298,000 seasonally-adjusted annual pace—the lowest level in five months. While sales fell in the South and West, they actually increased in the Northeast and Midwest. The overall report surprised some people who had expected a small increase, considering the low level we have been “stuck” at for some time. Competition from cheaper, existing homes is certainly hurting prospects for homebuilders. If this pace continues, 2011 may well be the worst year for new housing since records began in the early 1960’s. From a long-term standpoint, it is important to keep in mind that we are not currently producing enough homes for meet replacement and demographic growth demand—which cannot go on indefinitely—and may put a “floor” of sorts into the equation.
Durable goods orders increased 4.0% for July—better than expected. A good part of the report was due to larger aircraft, vehicle and metals orders. The “core” part of the report (non-defense, and excluding aircraft) showed a 1.6% decline, which was roughly consensus. Core shipments showed an increase, which was encouraging.
Initial jobless claims rose unexpectedly to 417,000 for last week, but almost 9,000 appear to be related to the labor strikes at Verizon. Excluding that effect, the figure was only slightly above consensus estimates. Continuing claims fell by 80,000 down to 3.6 million.
The second estimate for Second Quarter 2011 GDP was revised down from the first advance report of 1.3% to 1.0% (quarter-over-quarter, annualized). This wasn’t unexpected, but ended up being slightly lower than the consensus estimate of 1.1%. Interestingly, inventories were revised down but consumer and business investment were revised up.
Fed Chairman Ben Bernanke spoke at Jackson Hole on Friday during the much-heralded annual Fed retreat. Unlike the speech last August, in which he discussed QE2, this year’s comments were relatively tame. He emphasized the “wide range of tools” still available to the Fed as well as an optimistic view on America’s potential for long-term growth. What the “tools” comment is widely assumed to refer to is use of additional Fed balance sheet activity in bringing down rates by focusing efforts on the longer-end of the bond market, as opposed to the short end.
Market Highlights
The “risk-on” trade appeared to be the primary story of the week from a performance standpoint. U.S. stocks snapped a four-week losing streak, as the S&P was up 4.7% on the week. Similarly, the small cap Russell 2000 gained around 6%. From a sector standpoint, technology and industrials were the best performing, while utilities and consumer staples gained the least. The MSCI-EAFE was also up, roughly 3%, while emerging markets gained a more meager 2%.
Investment-grade bond prices largely fell—by about 0.5%—as interest rates on the bellwether 10-year Treasury rose from 2.07% to 2.19% on the week. Developed and emerging market debt was down slightly during the week, in line with domestic bonds and a dollar that was roughly flat.
Both U.S. and foreign REITs were up about 3%, similar to equities. Commodity markets were up in line with other risk assets as oil gained 3% and grains were well up over 5%. In keeping with the continual risk-on/risk-off trade, gold lost 1.5% on the week and silver a bit more than that.
Until Next Time
Enjoy the last few weeks of summer.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.
480-895-0611
World financial history has been characterized by a series of periodic manias. There have been more than two dozen key manic events during the past several centuries (and that only includes those formally recorded—there have been others and for much further back than that, based on anecdotal accounts). Often, bubbles begin with a rational concept, such as high-growth new technologies/industries, real estate in a new area, or some other new/unique asset that suddenly becomes popular (a key example being Holland’s tulip bulb mania of the 1600’s—when plants briefly turned into valuable financial property). Bubbles have also had a tendency to begin as an unintended byproduct of other conditions or policies, such as newfound levels of discretionary wealth or easy borrowing conditions.
Bubbles are remarkably easy to see in hindsight but can be difficult to discern while in progress. They are characterized by several factors and you’ll note many of them are not economic-oriented at all, but are more closely linked to tendencies in human behavior. A few of these include: herd mentality (need to be accepted socially by others, to follow what our neighbors are doing and think how they think, as well as the desire to avoid being “left behind”); extrapolation (tendency to take current conditions, such as rising prices on a chart, and assume that same pattern trajectory will go on indefinitely); confirmation bias (listening only to information that confirms one’s views, rather than information to that opposes them); and situational uniqueness (that’s a term we just came up with since the condition is a combination of several others—but implies a dramatic “new normal,” where conditions that would have been bubble-like in the past are now very different, are now a “rational” idea—so, consequentially not a bubble at all).
We’re sure many of these sound familiar when we look back at recent manias, such as internet stocks in the late 1990’s and residential housing through the 2000’s. Rationale used just a few years ago was that we have somehow evolved beyond being prone to bubbles in our basic nature. That nature is the interplay between fear and greed, of course.
If you strip any market down to its essence—no matter the asset or the situation—you’ll find a network of competing buyers and sellers bargaining for the best price. This is true whether you are dealing with homes, stock shares or bushels of wheat. In the final stages of a bubble, the asset in question has become more and more popular, and interest eventually deepens and broadens to all levels of society. This addition of more and more buying demand continues to move prices higher and higher as more buyers convince themselves of an asset’s underlying “value” and how even higher prices (or implausibility of lower prices) in the future are inevitable. This is known as the “greater fool” theory at work, which is the notion that there’s always a hypothetical buyer out in the horizon when you’re ready to sell at a higher price.
In modern times, TV and online media has served to act as an accelerant, through commentary and advertisements—which both serve to “vindicate” the rationale for an asset’s value. Of course, many of these same commentators seem to be peers of each other, and tend to listen to and reinforce each other. An anecdote attributed to JFK’s dad, Joe Kennedy, Sr., back in the late 1920’s, was that he knew a crash was inevitable the day he began getting stock tips from a shoeshine boy. This is indicative of classic bubble behavior, similar to when we saw lower-wage workers qualifying for no-doc mortgages on second and third homes with no money down.
Fast forward to present. Lately, we’ve been asked if gold/precious metals and Treasury bonds are in bubble territory. Of course, that’s difficult to answer at this point, but we can look to market behavior and sentiment as a guide. Both investments have been strong and consistent for several years, which has contributed to their popularity. In the case of precious metals, it’s rare lately to see a financial website without references or advertisements featuring pictures of shiny gold or silver bars. It is also a tangible asset, so people feel like they own “something”—also appealing when less tangible assets are mistrusted. In fact, often when we’re in conversation with the non-financial public, gold and “investments that don’t have any risk of losing money ‘when the world comes to an end’ ” are among the first things we’re asked about. Interestingly, the local news in our area last week described an alleged gold coin investment fraud perpetrated by an advisor/radio host—fraud has tended to appear during the latter stages of bubbles as investors’ fear of being “left out” finally overcomes normal skepticism.
Using the criteria mentioned, it might seem gold is acting more “bubble-like” than Treasury bonds, but, if a person were to include all available “safe” assets—such as savings accounts, low-yielding CD’s and other cash- and low-risk vehicles—the entire group has experienced rampant popularity. Both started as viable ideas: gold as a classic portfolio hedge against inflation and global geopolitical/currency uncertainty; and “safe” assets as, well, a lower yield in exchange for those with very short timeframes or demanding lower risk and/or complete principal protection. When we think about the sentiment behind these assets together, it appears we may have a potential bubble in “safety.”
Perhaps where we are in the bubble status is, again, unanswerable. But it does leave us with the question of who’s left to buy “safety” when safety gets too expensive (whether that’s measured by a dollar price per ounce or an extraordinarily low and uncompetitive interest rate). Another way to look at this is: if everyone has accepted and jumped on the bandwagon of widespread economic collapse, who’s left to fear economic collapse? That’s the question at the margin that may end up providing the catalyst for a re-emergence from fear into realizing “we’ve been through this before and made it out… we’ll do it again.”
It also brings up the concept of an “anti-bubble,” referring to an asset so unpopular that even good news can’t motivate buyers. Imagine the behaviors noted above from a negative mindset: herd mentality (an ignored asset no one wants to brag about owning—those who do venture in tend to be the “lone rangers”/contrarians); extrapolation (projecting assumed continued high volatility and bearish prospects for an asset with strong long-term performance); confirmation bias (focusing attention on news that points to catastrophic outcomes, while discounting any positive signs—forgetting that a mix of the two is more typical); and situational uniqueness (not realizing that the world is constantly changing, is often in flux, but problems aren’t really “new” and tend to be overcome with time).
Based on investor outflows from equities and into fixed income and other assets, it appears that concepts like global growth and risk assets like stocks may be in the “anti-bubble” zone. Retail investor cash flows (with a herding tendency) seem to confirm this. Investors withdrew an estimated $23.5 billion from US domestic equity mutual funds in the week ended August 10th—the largest weekly outflow since October 2008. In total, U.S. domestic equity funds have recorded $56 billion in net outflows this quarter so far, compared to $25 billion in the 2nd Quarter.
Food for thought, anyway, for the contrary thinkers out there.
Economic News
The Richmond Fed Survey of manufacturing activity showed a bit more economic weakness than expected for August. It seems that Richmond (which covers the Mid-Atlantic States, DC and the Carolinas) isn’t always watched particularly closely, but now that growth rates have fallen, all reports are seeing greater scrutiny.
New home sales for July declined a bit more than expected, by -0.7% to a 298,000 seasonally-adjusted annual pace—the lowest level in five months. While sales fell in the South and West, they actually increased in the Northeast and Midwest. The overall report surprised some people who had expected a small increase, considering the low level we have been “stuck” at for some time. Competition from cheaper, existing homes is certainly hurting prospects for homebuilders. If this pace continues, 2011 may well be the worst year for new housing since records began in the early 1960’s. From a long-term standpoint, it is important to keep in mind that we are not currently producing enough homes for meet replacement and demographic growth demand—which cannot go on indefinitely—and may put a “floor” of sorts into the equation.
Durable goods orders increased 4.0% for July—better than expected. A good part of the report was due to larger aircraft, vehicle and metals orders. The “core” part of the report (non-defense, and excluding aircraft) showed a 1.6% decline, which was roughly consensus. Core shipments showed an increase, which was encouraging.
Initial jobless claims rose unexpectedly to 417,000 for last week, but almost 9,000 appear to be related to the labor strikes at Verizon. Excluding that effect, the figure was only slightly above consensus estimates. Continuing claims fell by 80,000 down to 3.6 million.
The second estimate for Second Quarter 2011 GDP was revised down from the first advance report of 1.3% to 1.0% (quarter-over-quarter, annualized). This wasn’t unexpected, but ended up being slightly lower than the consensus estimate of 1.1%. Interestingly, inventories were revised down but consumer and business investment were revised up.
Fed Chairman Ben Bernanke spoke at Jackson Hole on Friday during the much-heralded annual Fed retreat. Unlike the speech last August, in which he discussed QE2, this year’s comments were relatively tame. He emphasized the “wide range of tools” still available to the Fed as well as an optimistic view on America’s potential for long-term growth. What the “tools” comment is widely assumed to refer to is use of additional Fed balance sheet activity in bringing down rates by focusing efforts on the longer-end of the bond market, as opposed to the short end.
Market Highlights
The “risk-on” trade appeared to be the primary story of the week from a performance standpoint. U.S. stocks snapped a four-week losing streak, as the S&P was up 4.7% on the week. Similarly, the small cap Russell 2000 gained around 6%. From a sector standpoint, technology and industrials were the best performing, while utilities and consumer staples gained the least. The MSCI-EAFE was also up, roughly 3%, while emerging markets gained a more meager 2%.
Investment-grade bond prices largely fell—by about 0.5%—as interest rates on the bellwether 10-year Treasury rose from 2.07% to 2.19% on the week. Developed and emerging market debt was down slightly during the week, in line with domestic bonds and a dollar that was roughly flat.
Both U.S. and foreign REITs were up about 3%, similar to equities. Commodity markets were up in line with other risk assets as oil gained 3% and grains were well up over 5%. In keeping with the continual risk-on/risk-off trade, gold lost 1.5% on the week and silver a bit more than that.
Until Next Time
Enjoy the last few weeks of summer.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.
480-895-0611