A Reality Check for Every Millennial Investor Regarding Bubble Bursts

 In Bond Investing, Personal Finance

bubble bursts

Being an investor, one of the biggest worries you’ll ever have is that your success is short-lived – that you’re only making money because of a bubble.

You may feel bullish at the moment, but when you get to thinking about it, your confidence may rely on a momentary lapse in judgment by the entire investor community. That’s basically all a bubble is, and every single bubble bursts eventually.

As a millennial, you should be especially sensitive to bubbles. We just went through a huge one with the housing market and not too long before that; there was the dot-com bubble. Still, I hear from millennial investors all the time who are clearly setting themselves up to become a victim the next time a bubble bursts.

Here’s the reality check I believe a lot of you need before you invest another single solitary dollar.
Bond Investing Fundamentals

The Stock Market May Fall – Hard

This is probably the biggest pill a lot of young investors need to swallow. It may not be a bubble that bursts soon, but an entire investment vehicle.

So while many savvy investors are trying to find the next hot stock or short those their research tells them is overrated, everyone will be standing on a house of cards – one that may be ready to fall very soon.

For a better explanation as to this bleak outlook, let’s turn to Bill Gross of Janus Capital. He recently went as far as to say, “The stellar returns experienced by both bond and stock investors over the last 40 years are an anomaly that will not be repeated.”

Gross’ analysis is, well, engrossing. However, for now, I’ll simply summarize his points with another quote: “For over 40 years, asset returns and alpha generation from penthouse investment managers have been materially aided by declines in interest rates, trade globalization and an enormous expansion of credit – that is debt.”

That doesn’t mean that some smaller version – which would still be devastating – isn’t possible or even impending. Gross is far from the only one who sees a bubble building at the moment and, again, every bubble bursts.

“There is an old investment rule-of-thumb called the Rule of 20 that uses combinations of headline inflation and the S&P 500 P/E to determine fair value,” says, Richard Bernstein, the CEO of Richard Bernstein Advisors.

“Our valuation models are, of course, more elaborate than the simple Rule of 20, but based on a more rigorous analysis of inflation and P/E ratios, the current equity market appears, at worse, to be fairly valued.

Investors forget that inflation was increasing leading up to the 2008 bear market. In fact, the CPI, which is a lagging indicator, peaked at 5.6% in July 2008. Today’s headline inflation is 1.0%.”

The financial blog First Rebuttal finds that Bernstein is reporting a bit of a half-truth, though that is certainly better than a lot of market analysts currently out there.  To be specific, the blog points to an evident inverse correlation occurring between inflation (the blue line on the chart below) and P/E (the red line below).

bubble bursts

This finding would support Bernstein’s suggestion that times of low inflation bear greater P/E multiples.  Yet, back in 2000, P/E finally made it through a ceiling on the long-term P/E movement that lasted 120 years even though there were far lower historical inflation amounts across that time period than we are seeing right now.

This implies that although inflation is having some impact on today’s valuations (which are almost record setting), the P/E continues to be roughly 28% more than what it should be once you take inflation into account.  Therefore, they need to be a little more thorough than Mr. Bernstein was if they really hope to understand today’s multiples.

The 10-Year Treasury Yield vs. the Market Earning Yield

This one isn’t so much a bubble regarding the stock market, more in terms beliefs. At the moment, a lot of investors are incredibly bullish because the 10-year Treasury yield is so dwarfed by the current market’s earning yield.

The problem with this optimism – which has swept up so many traders in its grasp – is that there is absolutely no historical evidence that the relative nature of these two elements makes a single difference as far as the future of the market is concerned.

Go back over the last century and you’ll see that I’m right. The only correlation you’ll be able to find between these two elements is that the stock market’s average return actually tends to be pretty dismal following any times when the spread was anywhere near where it is now.

bubble bursts

Bond Bubble

Despite the fact that the 10-year treasuries rate is at a historical low, it has room to go down further, even to the negative level. Currently, $13 trillion of global bonds, including 10-year German bonds, are traded with a negative yield.  You know that yield correlates inversely to the price.

This means that we are currently witnessing a historic high of 30 years in old bull market US Treasuries.

bubble bursts

 

There is also enormous potential for a corporate bond bubble, particularly in a speculative grade credit. Therefore, the risks of the structural downsides for high-yield loans and bonds are material, with risks for growth that are a non-negligible downside.

“We believe roughly 40% of all issuers are of the lowest quality, and roughly $1tn which will end up ‘distressed debt’ in this cycle,” UBS’ Matthew Mish wrote in a note to clients. “Much of the debt was bought to pick-up yield linearly, but the default risk is exponential.”

bubble bursts

Fortunately, this one seems unlikely for now.  However, if the corporate credit bubble bursts anytime soon, it could be to the tune of some $1 trillion.

When the $1 trillion bubble finally pops, it may only happen in the speculative market. Nonetheless, it will have far-reaching effects on all corporate credit. It will also freeze issuance and widening spreads. In turn, this could then slow economic activity and even US growth at some point.

Download Free E-Book “Bond Investing Fundamentals”

Not Even Silicon Valley Is Safe

When most people think about Silicon Valley, they think of tech millionaires and billionaires, many of whom aren’t even 40 yet. Silicon Valley is as synonymous with wealth as it is with computers. From Facebook to Snapchat to countless other companies, this place launches companies into the stratosphere, right?

Well, yes and no. The majority of startups fail; we all know that. However, this isn’t the reason why there may be a startup bubble in the works. It’s because these private companies can court investors without the same types of disclosures. If you know anything about Silicon Valley – and startup culture in general – then you already know that bravado and confidence are not something that’s lacking. These companies have no problem using hyperbole to stack the deck of public opinion in their own favor.

As such, a lot of startups are able to pull in wealthy investors who are positive they’ve found the next Facebook. Most of them aren’t even close to being right. Unfortunately, many of these people are also in charge of other people’s money, which is why this bubble is especially scary. While no one wants to see an American staple of ingenuity and wealth get a black eye, if Silicon Valley implodes, a lot of investors – many of the Millennials – are going to feel the consequences.

Housing Bubble Is Brewing Up Again

Sadly, just about any market is vulnerable to bubbles. Whenever you have low-interest rates and money is cheap – which we’ve recently experienced as a part of the Fed’s quantitative easing – the likelihood of a bubble appearing increase greatly.

Look at the housing bubble; it’s a perfect example. The dot-com bubble was too. We’ve just covered a potential stock market bubble, though that has less to do with interest rates, and I’d also add that a student loan bubble is growing to the point of becoming dangerously close to bursting.

By the way, we might not be out of the woods where the housing market is concerned. A recent report that looked at U.S. home prices showed that the market is growing far ahead of the rate of inflation.

This is no small thing. The report, which was done by S&P CoreLogic Case-Shiller, reviewed the status of the housing marketing in 20 cities. It reported that prices had gone up 5.2% over the past year.

Unfortunately, it gets worse. This increase in interest rates was part of a streak that had begun in September 2012 with the annual price appreciation on a home outpacing consumer prices. During that same year-long period, prices only went up 1%.

bubble bursts

Clearly, this can’t continue. Either the economy needs to find a new gear – and quickly – or house prices are going to drop. Therefore, this could be the beginning of yet another housing bubble. Hopefully, we can avoid the kind of devastation we saw over the past decade, but anything is possible.

Student Debt Bubble Bursts to Look Out For

The Fed has just provided its quarterly update on both auto and student loans. Unfortunately, we have a new all-time high in the value of student loans, which just reached $1.4 trillion.

bubble bursts

More and more people are enrolling in college – and taking out loans to do so – yet the unemployment rate remains high and the majority of college graduates never use their degree. Instead, graduates end up with the lowest paid jobs available, those in the “food services and drinking places” industry, also known as waiters and bartenders,

Below, the chart shows that there have been half-a-million bartender and waiter jobs added to the economy since 2014, yet not a single manufacturing job.

bubble bursts

Still, student loans remain one of the few forms of debt you can’t shed, even if you declare bankruptcy.

In closing, no, I’m not saying don’t invest. What I want you to take from this article is simply not to be trigger happy and follow the crowd. This is how bubbles happen, and it’s also how they eventually burst wide open.
Bond Investing Fundamentals
The article has been initially published on the SeekingAlpha.

 

Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
Recommended Posts