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Nexvu on Economics, Politics and the Markets

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Bubbles and Such

Posted by nexvucapital on February 15, 2013

We dislike the term ‘bubble’ (hence no capital on the word) as it is just another attempt to simplify and tag a complex market interrelationship. With that said we wanted to provide an overview of the concept.

Investopedia definition of ‘Bubble’ (their capital, not ours)

“Bubbles form in economies, securities, stock markets and business sectors because of a change in the way players conduct business. This can be a real change, as occurred in the bubble economy of Japan in the 1980s when banks were partially deregulated, or a paradigm shift, as happened during the dotcom boom in the late ’90s and early 2000s. During the boom people bought tech stocks at high prices, believing they could sell them at a higher price until confidence was lost and a large market correction, or crash, occurs.    Bubbles in equities markets and economies cause resources to be transferred to areas of rapid growth. At the end of a bubble, resources are moved again, causing prices to deflate. Thus, there is little long-term return on those assets.

Read more:

We agree with most of this description and wanted to add a couple of items:

  • bubbles are relative which means other assets remain normalized or devalued versus the bubble asset
  • bubbles are emotional movements of excess capital into an asset class based on any common historic measurement
  • bubbles require mainstream media support
  • bubbles are almost religious in their fervour at their peak
  • bubbles have been with us forever
  • bubbles occur at the end of a long-term rational upward trend in an asset or asset class relative to an investment theme
  • bubbles reflect irrational ‘belief’ or “exuberance” that an asset or asset class based on that long-term upward trend can only go ‘up’

A recent general market ‘bubble’ (that is currently unwinding) is ‘Safety’. Do not misunderstand this statement. Diversification over asset classes is a recognized asset management technique and involves placing a portion of ones assets (based on their risk tolerance and investment objectives) into assets that are deemed ‘safe’ or a hedge against the more volatile assets in the portfolio. BUT, since the 2008-2009 meltdown this portion of the majority of asset portfolios has received excess amounts of capital relative to other asset classes and this has been based on the emotional belief that another 2008-2009 event is just around the corner. We have one comment, once-in-a-generation market anomalies are exactly that unless one invests over several generations. OK, dude so where’s the proof…

1. US Treasuries since the mid-point of 2011 – see the 10 year chart of TLT where the 2011-2012 ‘Safety bubble’ dwarfs the reaction to the real-event in 2008-2009.

TLT 10

2. Gold since the mid-point of 2011 – see the 10 year chart of GOLD where the 2011-2012 ‘Safety bubble’ dwarfs the reaction to the real-event in 2008-2009.

Gold 10

Please note that gold has multiple inputs to its value including industrial demand and we recognize the use of gold as an investment strategy for the purposes of hedging inflation but gold has been ‘bubbling’ as a ‘Safety’ asset.

3. Cash accumulation since the onset of 2008-2009 has a similar chart to the above.

This leads one to the obvious questions of how one can identify ‘bubbles’ before they become ‘bubbles’ in order to take advantage of them as an above-average-return investment opportunity. Our thesis is that a ‘bubble’ is a socialized group-think phenomenon which means that they require ‘massive’ acceptance within the general populace in order to influence large capital flow movements. This is key – the media have to be involved in the creation of the ‘bubble’. Not as overt proponents but the media must carry the message to the masses in order for it to influence the investment behaviour of so many and create a ‘bubble’. Therefore, the proximal precursor to a ‘bubble’ is that the asset must be getting more than normalized interest from the mainstream media and the financial media. If one looks at every asset or asset class ‘bubble’ one will find that the asset or asset class was in the daily dialogue of the mainstream media just before and all through the ‘bubble’ phase. The ‘bubble’ is over when the same coverage transitions to negative commentary overwhelming positive commentary as a reflection of the air coming out of the ‘bubble’. The air comes out of a ‘bubble’ when almost everyone owns the asset or asset class.

We are of the view that in order to fully capture the benefits of a ‘bubble’ as an investor one needs to be an investor in the asset or asset class prior to the onset of the ‘bubble’ – should one occur or one should short the ‘bubble’ at the top (a difficult task as ‘bubbles’ do not always present obvious tops and usually test old highs before they lose their air). This is very important, because many pundits claim the ability to predict the ‘next bubble’ (a term we despise even more than the term ‘bubble’). Therefore, it is logical that one should not be looking for ‘bubbles’ one should be looking for the antithesis of ‘bubbles’. For example, if the above ‘safety’ trade is truly unwinding a ‘bubble’ then what is the antithesis of the ‘safety’ trade – RISK. We have added a chart for SPY and even though it has moved up since that generational buying opportunity in 2008-2009 it has still not exceeded its 2007 high. Now go back and look at TLT (pre-2008-09 ~$100 and post high is $132) and Gold (pre-2008-09 ~$1000 and post high is $1900). When one looks at the fundamentals underlying the S&P 500 can one say they are excessive versus the norm?

SPY 10

Now for an extreme. The S&P TSX Venture Index (VIJX or $CDNX) is what we would consider the absolute measurable antithesis of the ‘Safety bubble’.  This is a resource exploration index and we have added a chart below. Even though it bounced up after that generational buying opportunity in 2008-2009 it has still not come close to its 2007 high (pre-2008-09 ~3400 and post high is ~2500 and currently sitting at post 2003 recession lows of ~1200). When one looks at commodity prices (the fundamentals), is the current value of this basket of companies excessive versus the norm or a pure antithesis of the current ‘bubble’ unwinding in “Safety’?



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