I may be old, but I’m hoping that at least I’m getting some wisdom out of my experience. The MacroTourist recently wrote about the potential for a bubble in fixed income and why you just can’t know.
I’m not English. And it may seem that I disagree with The MacroTourist (I highly recommend the blog) about the bond bubble. I do not. Instead, I firmly disagree that you can’t know. Oh, you know!
I remember the dot-com era. I was trading stock options toward the end of it. As it turns out, I also happened to be at the epicenter of it in San Francisco. Trust me, unless you had no idea of anything or were kidding yourself, you knew something was up, even if not exactly what. That made me think about what was actually going on and what contributed to making it a bubble rather than merely a bull market. I recall at the time, at my worldly wise age of 29 or so, calling it amateur hour. Which it completely was. That was the first clue: the monkeys had taken over the zoo.
Here is my bubble checklist:
- There is good fundamental reasoning for the direction of things that is not initially obvious to everyone, e.g., Internet or tulip bulbs.
- A good run in that direction gets going, catches people unaware, invites those drawn to mean reversion to fight it.
- A new, large group of amateurs is suddenly drawn into the market in a big way, overwhelming the ability of the market and professionals to keep it all in perspective. Professionals convert from a mechanism of determining value to trying to front run amateurs. Those stuck in the old method often throw up hands and give up.
- Easy money/too much debt. Usually, this is where fraud/Ponzi schemes/investing in sock puppets occurs.
- A feedback loop as the price becomes the story and goes to “ludicrous speed.” This is where the actual bubble is: prices that so clearly violate any sense of economic justification.
Often people focus on some of the accouterments of a bubble, such as magazine covers or that taxi drivers are talking about stocks. Those are good symptoms to watch for, but they are not required. The key to a market being in a bubble vs. merely being in a bull market is the extreme positive feedback loop that brings a market into territory that is so very clearly nonsense, yet the price action creates a psychological need to participate so as not to lose out.
How and where does it end? Let me stress this because this is a fundamental rule of investing (if only I were to follow this myself): FOLLOW THE MONEY. When the money starts drying up–no matter what the stated reason–the buying power dissipates and the party ends.
The dot-com bubble
I began forming these criteria during the dot-com boom of the late 1990s. It should be no surprise that my criteria fits that period. Consider the backstory: a new technology, the Internet, is not only going to help everyone, but its network effects are going to increase productivity and wonderful-ness exponentially. As any story goes, and particularly one that ends up being so much of a revolutionary force, it takes time for it to become real for the majority. So the initial boom in the Internet and its related businesses was real–and not only real, but focused on the best of the prospects, because at first there were only a few ways to invest. This began happening in earnest in 1994-95 with the Netscape IPO, but as #2 states, things kept chugging along as the trend continued. Checklist #1 and #2.
This is where things got interesting. Two major changes altered the process of investing. The lesser was finance TV: CNBC (may somebody please put it out of its misery). It appeared to be for the professional, but was really for the amateur. The far bigger change was a fundamental leap in the way that people invested. The Internet made stock investing cheaper, easier and far more widely available into the hands of the public, i.e., amateurs, right at the very time that the real Internet story became exciting. For those who were not around for it, the amateurs watching CNBC, in stock market chat rooms and forming investment clubs ruled the roost. The evidence was overwhelming, but for a few examples, consider the Palm spinoff from 3Com (deserving its own story), the curious case of K-Tel going stratospheric at the announcement of a website and just the phenomenon of stock-split investing. Every real professional investor’s acumen was questioned, including Buffett, as any number of abject, ignorant amateurs were printing money using unbelievably irresponsible trading styles. Checklist #3.
The easy money (#4) of the mid- and late-90s is a bit harder to spot. The Fed raised rates in 1993 after a long period at 3%, and the 25bps caused a Wall Street enabled the Orange County Treasurer to bankrupt his municipality. However, that very bankruptcy laid bare what was going on behind the scenes: a dramatic expansion in bank balance sheets via repo markets and derivatives. Today we call that “shadow banking.” Back then, it simply expanded rapidly without a name. To take that sugar high to its heroin-level conclusion was the decision by the Fed to flood the market with money in 1999 in a risk-management effort to stave off potential problems due to the Y2K (year 2000) problem. The also significant source of easy money was venture capitalists literally giving money away in an effort to fund the next Yahoo! and get first-mover advantage via customer subsidization.
There is not much more FOMO than you can get (well, ‘til 2006) in a market that was climbing at 20+% per year and Jeremy Spiegel calling for Dow 36,000. To put it in perspective, the best-performing equity strategy in 1999 was pairs trading: buy the companies losing the most per share and sell those making money (#5!). That’s not a typo, and I encourage you to check it. I dare you to. The feedback loop was twofold. First, there was a de facto but not literal Ponzi scheme as the now rapid spread of the Internet meant more and more online brokerage customers coming on at an exponential pace. Essentially, the first people buying didn’t even have time to sell as wave after wave of new brokerage customers came into the market. Second, those same online brokers met the oncoming crush of customers with the welcoming arms of margin financing, which leaped to new highs.
There are the five components. Perhaps I’ve missed something, and I’d love to improve my thesis. It ended like all other bubbles: badly. Once into 2000, the Fed turned off the Y2K money spigot and began raising rates. At this point, however, much had happened. Many of the biggest names in finance had thrown up their hands in disgust at the amateur hour that was happening around them. Buffett’s reputation was in disrepair. Not the ongoing question of his backing of companies and people of questionable ethics, but it was widely questioned whether he had lost his touch. Julian Robertson’s Tiger Fund closed. Soros, after claiming he couldn’t figure it out, had gone all in long in 1999. Once rates had gone higher, many began saying that higher rates would not impact the stock market. The market cheerleaders noted that the Internet companies didn’t have debt, didn’t need to raise debt and would not be impacted. It all looked good for a while, but in short order (April), the market was starved of its oxygen (cheap money) and it all came down in a heap.
The housing bubble
It was all quite similar in 2005, although there was not the great investment story of railroads, chemistry, automobiles or the Internet. The story was financial alchemy. Re-hypothecation, shadow banking, backed by cheap money from the Fed and no supervision by any regulators (including the Fed), created a nearly endless money supply. The surprising part of this story is that from all of the evidence, the bubble was planned as a way to bounce back from the dot-com bust.
As usual, the initial stage of the story was mostly good as companies were able to more efficiently use their balance sheets as assets, such as loans to customers, were able to be financed at more attractive levels as the assets functioned as collateral. Then, as we know, things got out of hand as (1) amateurs moved into a market (real estate) that began to take off and then reached valuations that created the story itself, and then (2) completely new amateurs came into the market in a big, big way: the SPV (special purpose vehicle). These were investment companies that bought assets and funded it with cheap, short-term money. Things became absolutely absurd when synthetic debt was created. What surprised even the veterans was that this expansion created its own money supply via the magic of collateralized loans.
We were renting at that time, and I can recall that visceral sense of panic when thinking about a home purchase. I knew something was wrong. I was quoting figures about home ownership rates, earnings yields of rentals and home value to income ratios. Yet when looking at my wife (who for some reason trusts my judgment), the price action made me feel as though we should just buy because otherwise it will move beyond our reach forever. One would look around and see otherwise completely financially ignorant and irresponsible individuals owning five buildings they had no idea how to deal with. The price became the fundamental driver of the market.
Honestly, so many things became co-opted, corrupted and absurd that it really just got hard to keep track of. Don’t even get me started on the complete BS about “no one” seeing a crash coming. Everyone saw it coming, but it suited everyone’s self interest. You know it’s bad when bankers themselves come out saying that banking is too big a part of the economy.
By the end, everything was literally a house of cards and was vulnerable to the gentlest of breezes. The yen carry trade was something of a canary in the coal mine, but it was the Bear Stearns fund troubles that got things going in earnest. Market participants had become so over-optimized to cheap money that they could not get out of the way quickly enough. As the market was built on cheap financing via collateral, the questionable value of said collateral dried up funding quickly and by massive amounts. The feedback loop now un-whipped with even greater force than it had come on with. Fear trumps greed.
The bond bubble
What about now? Are the same factors at work? I’d posit that there is a debt bubble. Which, of course, is quite odd considering the enormous size of the outstanding debt stock. But, as Michael Lewis said long ago in “Liar’s Poker”: supply has a funny way of hitting demand on Wall Street.
There is a good, fundamental reason to have originally purchased fixed income securities as there is a large overhang of debt to be addressed by the world, and that is a deflationary force. Check. Positive carry in at or near zero funding levels makes leveraged fixed income investing extremely attractive, even if price levels simply stay unchanged.
That qualifies for #1 and #2, but who is the new market entrant? Where is the value-insensitive buyer with unbelievably deep pockets? Where is the buyer who is absolutely sure of his method? The answer may not seem as obvious because the culprit is draped in credentials. The amateur money today is central bank balance sheets. Debt monetization schemes (QE)/government bond buying programs are price-blind purchases of fixed income securities. Regardless of one’s thoughts on the short- or long-term efficacy of the programs on the global economy, the Fed and its sisters have made clear that they are mega-large-scale, uneconomic buyers of debt (and equity). Uneconomic buyers–those who participate in a market but are price insensitive–are, by definition, amateurs. The size at which the central banks are playing dwarfs the rest of the market. Criteria #3: check.
In this case, the money is the easiest available. The Federal Reserve simply prints liabilities (dollars) and purchases assets (bonds). It then funds those dollars right now at 25-50bps. Most interesting about this easy money is that it appears to be particular to financial asset buying. The money is going into leveraged asset purchases, but is not making its way into the main economy. Bank balance sheets are not expanding. Easy money, #4: check.
Nowadays we don’t exactly have aspiring homeowners gasping with fear over a housing market moving forever away from them. Instead, we have TINA. For the uninitiated, that is institutional market panic for stocks and yield overall: There Is No Alternative. While that is catchy, it does not have the quite sensible basis in either theoretical or empirical research like, say, value investing. It has a ring of panic. “Yes, I know this is ultimately a money-losing alternative, but what choice do I have?”
Fixed-income investing is not like equity investing, at least for sovereign and investment-grade bonds. In equities, it is possible to buy a wildly expensive stock (say based on P/E), and the business delivers to a degree that makes the ultimate gains on the stock positive. Bonds don’t work that way. There is an inexorable trudge toward the maturity of the bond. That’s the nature of fixed income: the cash flows are fixed, even if the value of those cash flows changes. Generally speaking, fixed income focuses on income. Yet, due to central bank buying, yields are negative. Just to be clear, negative rates mean that bond investors are locking in guaranteed losses if held to maturity.
It is hard to stress enough how absolutely absurd this actually is. We have all grown inured to it like a bad smell that we have spent too long with. The reality is that in 5,000 years of debt, this has not occurred before. And while change can be good, this is a situation that turns everything on its head: one is getting paid to borrow money. Like the rich, negative rates are not like other rates: quite literally, one becomes a better credit risk by issuing more debt. That means that it becomes responsible to issue debt and buy any other liquid asset with it. In fact, it is the very ultimate endgame to punishing responsible financial behavior in investors (retail or institutional) and rewarding profligacy (mostly institutional). I’d argue that this is the most ruptured price bubble yet. So (sigh), #5: check.
I’ve explained my bubble framework and associated checklist. With so much talk about bubbles all of the time, it is easy to tire of it. That does not make it any less important. The best and brightest in no uncertain terms say that one cannot detect a bubble ahead of time. I disagree. Yes, you can tell, and yes, the bond market is in a bubble. There is a way to tell the difference between a bull market and a bubble. The difference is the positive feedback loop that occurs when professionals focus on trading based on the “greater fool theory” rather than value. And that occurs due to easy money in the hands of amateurs.