A Bubble? Not Really

What a few weeks back we might have deemed a “stealth rally” has gotten bit less stealthy of late. Indices spurt upward when the news is “good” (and even not so good, as when the Market soared following AMD’s trimming of its outlook) and then just kind of go through the motions on the inevitable “pull back & rest” days. This powerful upswing could reach something of a short-term climax around the upcoming earnings season coinciding with the “buy-the-rumor, sell-the-news” aspect of the November 2 election, but longer term it still has far to go. What I see as the motive force behind this expectation is, in effect, the subject of this Musings. It seems that whatever progress equities have made off of their March 2009 lows, it has been despite a raging flow of funds in the direction of fixed income. This torrent has been so profound as to stir something of a national conversation as to whether we are experiencing a “bubble” in bonds.

Musings takes the position that while there is certainly some of the attributes of classic asset bubbles in play, what is going on in bonds should not be considered a bubble. As the elephant would say, “Just because it has a trunk and birds like to rest on it does not make it a tree.” To call what has gone on in bonds of a late a bubble is yet another example of this age’s pernicious tendency to stretch and so mangle the meaning of words until they are nearly useless and certainly powerless. (What has become of “hate” in recent years comes to mind.) Sure, there is that lemming-like rush, characteristic of bubbles as their inflation picks up speed, by parties who don’t seem to be thinking very hard about it. That is indeed a sign of a bubble, but it is just a sign. I don’t see a bubble here because the basic motivation is Fear and not Greed, and because of the extreme unlikelihood of widespread, ruinous consequences that always follow real bubbles. The clamor for bonds is fear-based, an acting out of a preference for assured outcomes, however piddling, as opposed to blithely taking on more risk than one understands there to be in pursuit of a ticket to Easy Street. But it is the dearth of likely, adverse consequences of this phenomenon that make the misuse of “bubble” most apparent. Real bubbles end really ugly. Think of stocks that have one lap around the track and then implode to 5% of their peak value and never recover, or worse. Think condominium complexes and shopping malls that sit empty for years once the music stops, until they are so decrepit that bulldozing ends up being the most value producing option. Think gold coins purchased in 1980 and then sitting in your safe earning exactly nothing for the next twenty five years.

So what’s the worst that is going to happen to the moke who is willing to lend to the Treasury for ten years at only 2.5%? (Interestingly, as reported on 10/2 in the WSJ, the rush to bond funds has been very focussed on short to intermediate funds, with long funds seeing almost no net inflow.) Say three years from now inflation finally rears its ugly head, what’s he got then? Certainly not a worthless husk of nothing. He’s got a seven year note he paid 100 for selling at 90 or 85. In seven years, he get it all back at 100 and he will get that meager spurt of income every six months while he waits. A disappointment, sure, but hardly a disaster. Just ask the fellow who overstayed the Tech Bubble for more than a few weeks into 2000. This rush for specious certitude is a natural response to a couple of decades where the risks of ownership were soft pedaled and millions of householders got burned as a result. Now they are reacting in the opposite direction, and their stampede has enriched a clever few who saw (or guessed) correctly that a wave of cash would inflate the value of low-default-risk, income producing assets (i.e., another feature of bubbles, the emergence of a recognizable price momentum that becomes attractive in and of itself, if only for a season).

This phenomenon that some would call a bubble could go on for some time, but I suspect it is at the point where the leakage, the smart, early money starting to move on, starts kicking in. It will be very difficult (no, make that impossible) for bond funds to repeat in 2011 what they delivered in 2010. Besides, it has served its purpose. And what might that be? To ease the clear and present distress of certain borrowers at the longer term expense of certain lenders. By crunching short rates to where they are indistinguishable from zero, policy makers have actually inflicted hardship of the most risk averse of savers. They have made it easy for profligate states and municipalities to replace high cost debt (on which many retirees were subsisting) with lower cost debt (on which many retirees will be just getting by). Every week, debt issued before the Crash matures or gets called, and someone’s retirement income shrinks a bit. This is a “yield” problem for retirees, actual and prospective, that get worse almost every day. If such a saver was prescient enough to own longer term bonds, CDs or funds, the full impact of this squeeze has yet to register, in fact they might had a surprisingly good 2010, but the hurt will be upon them very soon.

The beneficiaries of this squeeze would seem to be the banks, municipal borrowers and the unions who are affixed to that set of teats we call the public sector (which needs to borrow heavily to keep their symbiotic scam going). And to be fair, they need all the help they can get. But who is paying for it? The patsy in all this is, once again, the unsophisticated saver just trying to get through life without doing too much harm. It is not hard to make out in this episode of record low interest rates a blatant transfer from one class to another. That’s not the narrative we get, but it seems to be the way the money is flowing. We are told that rates need to go lower to stimulate the economy and so create jobs, but how faux is that? Think about all the prospective corporate borrowers on a continuum that rates credit worthiness and the need to borrow. At one end you have all those companies that have record levels of cash. They might borrow more, indeed some have, if rates got ridiculously low, but does make them more vigorous, more expansive and so likely to hire? No, not really. Then at the other end of the spectrum are those entities that no lender in his right mind is going to lend to. They are just not credit worthy at any price unless they have portable, findable collateral. The $64 question then is “How much is left between these two categories, wherein lower rates have no impact, where lending and so expansion might actually occur if you lower rates?” My read is that it is a pretty small slice indeed. If so, this narrative about jump starting the economy by cutting rates is pretty bogus. Indeed, it is a dodge, a distraction from yet another transfer of wealth from those who don’t deserve what’s happening to them to those who don’t deserve the break their friends just delivered.

My confidence in the durability of the Bull Market that started in March 2009 rests in that pent up tsunami of safety-seeking money that has done okay for the past eighteen months but going forward is going to have to breathe deep and take a little more risk. Some households will be able to keep the belt tight and muddle on. Most others, one suspects, will simply have to find a way to get higher returns. As for pension funds, endowments, etc., or managers charging more than about 20 basis points, even more so. 2010 will probably end up being a moderately good year to have owned stocks. As the income from debt grinds inexorably lower, the trickle towards better options, like 3%+ yielding stocks of global corporations that can actually raise that dividend over time, will freshen and in time become a raging torrent. Along the way, this peculiar worry that has overtaken so much of Tech, that the fashion statement that is the handheld communicating & occasionally computing device is going to somehow undo the need for devices that can actually get work done, will dissipate as well. This will bring the valuations of many of those stocks back in line with their actual prospects. Then there is the unrelenting reminder that has been M&A: companies being taken out by entities that are going to have to live with them for a while at prices way above where the stocks had spent the past year. (Most recent example, see KEI, whose acquirer is hardly an ingenue in the acquisition game.) Put all these factors together, and it is plain to see that this Bull still has miles to go.