Bubbly New Year!

Happy New Year! According to Bloomberg, everything is fixed just in time for 2011. That’s great news and it matches what we have been saying all along, i.e. that the recovery is alive and well, just a little slow. Unfortunately it also means that the time is right for new asset bubbles.

No doubt the Federal Reserve will take credit for the decrease in unemployment claims and the pick up in business activity. However, it is unlikely that the purchase of $600 billion of government bonds in November had any impact on December’s economic indicators.

Historically it has taken at least half a year before a stimulus program begins to show an effect on the broad economy. This lag has made it very difficult for governments and regulators to stimulate the economy when the stimulus is actually needed.

Bailouts and stimuli are only politically acceptable if the situation is pretty grim. And usually the worst is over right around the time people start looking to the government for help. Even if the government acts quickly, any stimulus normally hits the economy six to twelve months after the recession has ended. At that point is often does more harm than good, because pumping money into an expanding economy tends to create bubbles.

The Federal Reserve’s bond purchases (Quantitative Easing 2) and the tax cuts for 2011 and 2012 are likely to create bubbles, but this early in the game is it hard to know which asset classes are affected.

Gold is almost certainly bubbling. Demand for higher yields has driven up the prices of riskier corporate and government bonds. US government bonds trade near all-time highs. Bond prices really can’t increase much from present levels, but they can certainly decline a long way.

Are these bubbles? It is hard to tell. Here are a few signs that indicate that a bubble may be forming:

  • It is easy to borrow money at low interest rates: The Fed is keeping rates low, and the growing number of leveraged ETFs provides one way individuals can borrow easily and cheaply to buy assets.
  • Public awareness increases dramatically: People talk about how much money they made in real estate, tech stocks, etc., dedicated magazines and websites spring up, media coverage increases.
  • Prices rise much faster than in the past. The price increase is justified by some form of ‘It’s different this time!’ but there is no underlying economic reason, such as a supply shortage, why prices should increase.
  • People sell other investments or borrow to buy more of the wonder asset.

If you know an asset class that may be forming a bubble, please let me know! It would be interesting to complile a bubble-watch list and check it periodically to see how things are developing.

Posted by Martin Gremm (Pivot Point Advisors)

About the author

Marc Schindler, CFP®

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