Another Bubble in the Markets

I’ve been reading the sections on bubbles and financial manias in the book Extraordinary Popular Delusions and the Madness of Crowds. It’s a worthwhile thing for investors to study. It has been written that Bernard Baruch decided to get of the stock market in 1929 after reading the book. I don’t know if that is true or not, but he did write the introduction to the edition I have. The book is timely because I think we may be in a bubble now, not anything so manic as the Mississippi bubble or the tulip mania, but still a bubble and a danger for investors.  

To illustrate, suppose I have three hot IPO stock tips for you. The first one which we’ll call A has the lowest earnings of the three. In fact its P/E is around 400, but it does pay out all of its paltry earnings to the investors. The annual earnings are not growing and are certain not to grow in even nominal terms.  The payout to stockholders is fully taxable as ordinary income.  The stock price can fluctuate somewhat with market conditions but in two years will be exactly equal to the  initial offering  price.

The second one, called B, pays a little better. Its P/E is a bit over 50, and all earnings are paid to investors in payouts that are fully taxable as ordinary income and certain never to grow. Even ignoring taxes, this payout produces a negative real return at the present official rate of price inflation. The stock price will fluctuate but in ten years is guaranteed to be exactly the present offering price in nominal terms, resulting in a real capital loss at the present rate of price inflation of about twenty percent, assuming the payouts were not reinvested.

The third deal, C, has the best payout of all with a P/E of around 30 with all earnings paid  to investors. Its returns, too, are fully taxable as ordinary income and guaranteed not to increase. Its real annual return at the present official rate of inflation is about 1%, but income taxes reduce that something between about 0.5% (at a 15% marginal tax rate) and a slightly negative return (at a 35% marginal tax rate). Its price will fluctuate with conditions but in thirty years is guaranteed to be exactly the present offering price in nominal terms, resulting in a real capital loss at the present rate of price inflation of a little less than fifty percent, assuming the payouts were not reinvested.

I doubt if very many people would want stocks A, B, or C as investments to hold, as opposed to speculations to trade. Of course they are not really stocks at all but rather bonds. A, B, and C are the two, ten, and thirty year treasuries, respectively.  

This looks like a bubble to me. Bonds have been in a secular bull market for over thirty years since the end of the inflation of the 1970’s which is  a long time for any bull market. The United States is in a period of serious monetary inflation. If that leads to higher rates of price inflation, it is likely that interest rates will rise and the value of bonds will drop.  The huge amount of debt the federal government owes gives it an incentive to use inflation as a means of repudiating part of its obligations. Then of course there is the simple fact that the potential price appreciation of bonds is capped. Rates normally will not go below zero, and when interest rates near zero there is very little room left for them to decline. Interest rates have rarely been this low in American history and have never before been this low in the time since World War II. It is also  telling  that these days among so-called experts  treasury bonds often are being touted not so much as conservative investments but rather as speculative instruments that could jump in value if interest rates move the right way.

I think we should be careful.