Bob Carlson

The investment world is full of those who say one or more assets are in bubbles or bubble territory. It’s exciting talk, but not very useful to investors. Bubbles are extremely rare, and overvalued assets can remain overvalued for a long time. Tyler Cowen of Marginal Revolution provides some clear thoughts on all the bubble talk. Take a look, and refer to it any time you see some other claim about bubbles.

1. I don’t find most predictive discussions of bubbles interesting, while admitting that such claims often will prove in a manner correct ex post.  “OK, the price fell, but was it a bubble?  I mean was there froth, like on your Frappucino?”  Or to quote Eisinger, it might also have been “dangerous signs of prebubble activity” (what happens between the “prebubble” and the “bubble”?  The “nascent bubble”?  The “midbubble”?  The “midnonbubble”?)

2. Good news and improving conditions may well bring more bubbles or greater likelihood of bubbles, but that is hardly reason to dislike good news and improving conditions.

The annual Secular Forum at PIMCO is an exciting event. All the professionals at PIMCO gather with some outside speakers to evaluate where the economy and markets are and where they are likely to head over the next three to five years. It was at the Secular Formum that PIMCO came up with the concept of the New Normal that is widely accepted and has played out largely in line with the forecast back in 2009.

The 2013 Secular Forum recently wrapped up, and Mohammed El-Erian presents the conclusions. What’s interesting is that El-Erian says this year’s discussions and analysis is the most difficult he’s been involved in. That’s interesting, because my communications with individual investors indicate they are more confused and uncertain than ever. PIMCO concludes that we are in a stable period but with disequilibrium. It can’t continue. At some point in the next few years, the economy will transition into either a normal, self-sustaining, growing economy, or it will turn into something bad. The big issue for investors is that because of stimulative monetary policy, the prices of many assets are not in line with fundamentals, but they could be very quickly if sustainable economic growth takes hold.

You should read the entire essay to see how the conclusions are developed and decide if you agree with them. I largely agree with the analysis, and it is consistent with what’s been guiding our recommendations at Retirement Watch. I repeat what I said in our recent webinar and in the June issue. Don’t fall for scary stories or extreme arguments. They are only going to paralyze you or cause you to make risky one-way bets.

Second, and related to the first factor, growth dynamics are notably heterogeneous and most growth models need to evolve. In the West, endogenous healing and significant short-term innovation accelerators are limited mainly to the U.S. – albeit a country still confronting headwinds from incomplete deleveraging and a dysfunctional Congress. Others face stronger self-made and exogenous headwinds. And some lack growth models altogether, and have low probability of successfully implementing new ones in the next three to five years.

This issue of growth models (as distinct from just growth) is an important one.⁵ Whether it is China with its transition from export-led to consumption-led growth, or the West in the aftermath of the global financial crisis, many countries need to evolve their engines of job and income generation. And while central banks are doing their utmost to buy time, their involvement can inadvertently push countries back toward old and exhausted growth models.

I am deluged by a lot of information explaining why stocks are a bad investment. The most common basis for being bearish is that stocks are overvalued. Some analysts like to compare stocks to their highs in 2007. Others point to the big market peak in 1999.

Here’s a good analysis that I think explodes the comparison to 1999. If that’s your standard, stock definitely aren’t overvalued today. The piece also takes apart what’s known as the Shiller CAPE valuation formula that uses 10 years of normalized earnings. Bottom line on that: the steep drop in earnings following 2007 was temporary and an anomaly. It distorts the 10-year data. The article is a good antidote to a lot of the sloppy data and analysis floating around.

The bottom line is, it’s stupid. Anyone can find similarities in the stock market action of different years. It’s not complicated – stocks can really only do some combination of three things, up, down or sideways. But this type of comparative analysis is, as always, a function of what details you choose to leave out. I can compare my house to the Taj Mahal if I choose to leave out quantitative factors like square footage or qualitative factors like its location or historical significance.

I want to remind you about some peculiarities from 1999 that you may have forgotten – some major market differences between then and now that I believe demolish the comparison.

Imma strangle this thing in the crib before it screws your head up.

The Federal Reserve is pumping up the money supply. So is the Bank of Japan. So, why is gold tumbling? Shouldn’t gold be rising on fears of inflation? Here’s a good review of the likely reasons for gold’s decline. One reason, of course, is that inflation isn’t rising. It takes more than money supply expansion to cause inflation, and a lot of people overlook that. They’ve been expecting higher inflation since the Fed started quantitative easing in 2008, and they’ve been wrong. They’ll continue to be wrong for a while longer. Add in low wages, a strong dollar due to a steady U.S. economy, and few alternatives outside the U.S., and it’s not hard to see why gold stopped rising.

Various reasons are offered for the latest move down. There’s chatter that investors had to liquidate some of their precious-metals positions to cover margin calls on their dollar-yen positions, after the Japanese currency rallied overnight. Some think it’s because bad weather is affecting the start of the Indian wedding season, a time of strong demand for the physical metal. Or maybe Indians are going off the metal because it’s just become too expensive, or the economy’s not doing so well.

Or maybe supply is starting to put a dent in the market. After all, relentless price rises tend to boost investment in extraction. It’s worth bearing in mind that shares in gold-mining companies have performed even worse than the metal–the Market Vectors Gold Miners exchange-traded fund is now down 60% from its September 2011 highs.

Michael Price is one of the great value investors. He ran the Mutual Series of mutual funds (now part of Franklin/Templeton) and achieved excellent returns. He sold the fund complex for a bundle so he could manage his own portfolio full-time. He recently spoke at a value investors’ conference. You can find notes of all the conference speakers here.

There was an interesting passing reference in Price’s talk that deserves more attention. Price said that in developing investment strategy we all need to forget about 2008. That makes a lot of sense. The crisis in 2008 was an anomaly. It isn’t likely to happen again because it required a large number of mistakes by investors, business managers, and government officials to create the meltdown of the financial markets. While such a thing could happen again, it is a very low probability event. You can manage your portfolio based on that low probability. Also, it takes time and a series of events to leads to a 2008 result. If such an event is percolating, you’ll have enough notice to adjust your portfolio.

Don’t invest your portfolio based on what worked in the 1980s and 1990s. Those days are gone. We’re in a different market and economic environment. But you also can’t invest with 2008 in your mind all the time. Instead, be diversified and balanced. Follow market momentum and Fed policy. And have a sell plan in place so you’ll be out of risky investments long before the worst of a 2008 event (or even something more mild) occurs, yet you’ll stay in the markets if things continue to heal.

A new study obtained data from a firm that consolidates information on a number of superwealthy families (average net worth is $90 million) and tabulated their holdings and trades. You can find a summary here (subscription might be required). The good things the rich do is they don’t trade much, invest in vehicles open only to the wealthy (hedge funds and private equity), and take tax losses quicky. The rich have about six advisers or money managers each.

But they don’t do everything right. The wealthy have a tendency to chase fads with the money that isn’t invested for the long term. One example in the study is that they steadily increased holdings of mortgage-backed securities as the 2000s went along. The also own a lot of individual holdings, perhaps too many to keep track of and to keep costs under control. They also do a better job of rebalancing their portfolios regularly, but not as good of a job as they should.

Hedge fund managers usually are secretive about their investments and strategies. Yet, periodically some of them appear at conferences and reveal some of their recent investments. The Ira Sohn Investment Conference in New York each year is one event that brings out a number of prominent hedge fund managers who talk about what they say are their best ideas. But following the tips they give isn’t a particularly good idea, according to The Financial Times. It’s not bad advice, but you’d do better with an index fund, according to a study the newspaper undertook.

But a Financial Times analysis of last year’s tips shows decidedly mixed results. An investor who followed every top idea from the 12 speakers last year would have made 19 per cent, less than the 22 per cent gain available from a passive index fund tracking the US stock market.

Many of the ideas have proved woefully miscued, including some from the most high-profile managers who will return to the stage on Wednesday: David Einhorn of Greenlight Capital and Bill Ackman of Pershing Square.

The two best performers were the rather less well known Larry Robbins of Glenview Capital, and Philippe Laffont of Coatue Management, neither of whom will be speaking again this year. Followers of the former would be up 60 per cent. He argued that healthcare stocks were cheap, ahead of a Supreme Court decision on the constitutionality of President Obama’s healthcare law, and that investors should sell ITC, a power transmission company.

Mark Mobius of the Franklin Templeton mutual fund firm spends a lot of time traveling around the world looking at companies and countries. Recently he visited China and took a look at the ghost cities and other evidence of a housing bubble discussed in the media. Here’s his report.

One of the reasons there are unoccupied apartments or homes in China is because many Chinese treat investing in property as a means of saving rather than putting money in the bank at low interest rates, or investing in the stock market, which many consider too risky. Property is something they can see and perhaps eventually use for themselves or their children. And given the very high savings rates in China, there are many who are able to pay cash for property investments and sit on empty apartments indefinitely.

More importantly, families across China need and demand affordable housing near work and school centers.

Most people who make investment and financial mistakes aren’t dumb. But they use the wrong thinking process. That’s one of the insights of Daniel Kahneman, winner of the 2002 Nobel Prize for Economic Science, though he’s a psychologist. In a wide-ranging interview, Kahneman discusses his book Thinking Fast, and Slow and the work behind it. He’s one of the founders of behavioral economics, though he doesn’t like the term.

That’s what Bill Gross of PIMCO says in his latest monthly essay. He actually says “there will be haircuts,” meaning bond investors will lose part of their principal or have lower returns as a result of several actions. The haircuts could take the form of principal reductions or forgiveness or inflation. They also could be from an artificial ceiling on interest rates that could be earned on bonds. Before financial deregulation, interest rates that could be paid on many types of savings were limited by law. Now, the Fed uses its quantitative easing to keep a ceiling on rates. Either way, savers lose.

Gross reviews the different ways investors could face haircuts, then he gives some advice about how to handle it.

So it seems as if the barber has you cornered, doesn’t it? Sort of like Sweeney Todd! Let’s acknowledge that possibility, along with the observation that all of these haircuts imply lower-than-average future returns for bonds, stocks, and other financial assets. If so, the rather mixed metaphor of “money’s goodness” and “avoiding haircuts” is still the question of our modern investment age. The easiest answer to the question of what to buy is to simply take your ball and go home. If the rules aren’t fair, don’t play. That endgame however, results in a Treasury bill rate of 10 basis points or a negative yield in Germany, France and Northern EU markets. So a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing. PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not “good money,” they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate.