The Big Bubble

Is there are bubble in asset values? It depends on how you frame the problem, timing, and it also depends on which version of finance theory you believe.

If you believe in rational markets, and adhere to the Efficient Market Hypothesis, there are no such thing as bubbles. I was at a talk once by Professor Eugene Fama and he said as much. He added, “If there was such a thing as bubbles, we would be able to predict them.” By predicting, he didn’t mean idle talk but actually constructing a mathematical equation or algorithm that could spit out a definitive probabilistic tested answer.

If you think markets are irrational, and you like the Robert Schiller view of markets, you see bubbles everywhere. Which market isn’t in a bubble today? On a macro level, asset values are rising everywhere.

For the average investor, it is impossible to predict and act on bubbles in any market.  This is why they are better off putting their money in a no load index fund and avoiding fees.  When they are younger, they should assume a lot of risk and buy the stock market exclusively.  As they near retirement age, they should start re-allocating to bonds and dividend paying stocks, along with a smaller amount of growth.

However, eyes wide open, I think I see a lot of disjointedness all over the market today. I have been absolutely wrong about inflation over the past couple of years.  But, I still think that the seeds for a pretty large inflation event are there.  If the velocity of money starts to turn over, it’s going to happen.

I think the best way to hedge yourself against inflation is to build a business, or invest in a business that will grow faster than the inflation rate.  That means taking some risk.  Pro investors are just starting to look at shifting some assets to early stage VC funds or other alternatives. If I look at the growth of some of the companies I have invested in, they certainly beat a lot of historical inflation rates.  The question then becomes how do these kinds of companies perform in adverse financial environments?  The answer is we don’t really know and its company specific.

Talking to interest rate trader friends of mine, they see the trade of a lifetime happening.  The question is when.  They are all trying to figure out strategies to short US bonds.  Today, Barry Ritholz retweeted this

Rosie: Wondering why 10-year yield is 2.4%? The BoJ, PBOC, & Fed have collectively absorbed 93% of net new bond supply over past year!

— Gluskin Sheff (@GluskinSheffInc) August 11, 2014

That tells you we are in very strange central banking times.  Central banks always absorbed a certain amount of debt, how much is uncertain.  Certainly, after a financial crisis, or a war, there is always a lot of government debt overhanging. We have had both in the US.

Nassim Taleb articulated his trading strategy in The Black Swan.  However, pursuing this strategy is expensive.  A broken clock is right twice a day.  Buying out of the money put options and continually rolling them isn’t a sustainable trading strategy most investors can rely on.

So, startup valuations are supposedly in a bubble.  The stock market is in a bubble.  The treasury market is in a bubble.  The housing market is showing signs of a re-inflating bubble.  Which bubble pops first?