Fire Burn and Cauldron Bubble

I had intended for the subject line to be Bubble, Bubble, Toil and Trouble, but I don’t know Shakespeare very well: it’s ‘double, double, toil and trouble, fire burn and caldron bubble!’  Since I wanted to write about bubbles, I went with the latter half of the statement, which still sounds fairly ominous.

The New York Times has a terrific new section, The Upshot, that featured an article yesterday titled, ‘Welcome to the Everything Boom (or Bubble?) that included a long list of antidotes about rising asset prices including Spanish government bonds, New York city real estate, Iowa farmland and, of course, US stock prices.

In the last few months, I feel like I’ve read a lot of articles about bubbles that mainly ask the question: are we in one, and, if so, how long before it bursts?

The Times article concludes by saying that ‘high valuations aren’t as extreme as those of stocks in 2000 or houses in 2006’ which is such a relief that I wish they had put this closer to the beginning of the article.  And, in fairness to the Times, the headline was about booms and just hinted at bubbles in the headline.

Still, though, the bubble story is gaining ground.  Two weeks ago, The Bank for International Settlements, which is also known as the central banker’s central bank, warned that financial markets were ‘euphoric’ and detached from reality.  They said that governments should stop policies that can induce bubbles, namely ultra-low interest rates.

The next week, Federal Reserve Chair Janet Yellen made a speech where she made it clear that she would not raise interest rates for the sole purpose of preventing bubbles.

She said, ‘monetary policy faces significant limitations as a tool to promote financial stability.  … [E]fforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment.’

In March, famed investor Jeremy Grantham who correctly predicted the tech bubble and then said to buy stocks in early 2009, said that if the S&P 500 traded at 2,350 on today’s earnings, we would be in bubble territory based on traditional valuation techniques.

At the time, the S&P was trading at 1860, so he essentially was saying that stocks would have to gain 25 percent to be in bubble territory.  Markets have run up since then, so prices would only have to increase by 19 percent from here to be considered a bubble according to his calculations.

Even he says that he doesn’t expect anything to happen until 2016, but he then warns that ‘it will end badly.’  Then again, a quick Google search found that he predicted a bubble in 2010 and stocks since then are up about 55 percent.  Is that evidence that he was wrong or that the bubble is even bigger now?

And that’s the point in my opinion.  It’s one thing to say that stocks are overvalued and that if they go up more (and earnings don’t) that eventually, you’ll be in a bubble.  That’s not hard – I know because I said as much last August and again in February, albeit without using the ‘b’ word.

What’s hard is being able to correctly say when a bubble might burst and by how much.  In fact, unless a bubble bursts, you can’t really say it was a bubble – you can only say after the fact.

What if you listened to Grantham and sold stocks in 2010?  You wouldn’t have to worry about whether stocks are in a bubble now, but you wouldn’t have as much money in your account either.  The gains of the past three years have built a nice cushion against falling prices.

If markets were easy to predict, we would do it.  Unfortunately, they’re impossible to predict with any consistency over time.  Some folks might get lucky periodically (Grantham?), but the truth is that nobody knows.

The key, therefore, is to set an appropriate asset allocation that limits your exposure to market declines.  Of course, that limits your exposure to gains as well, but the idea is finding the right balance of stocks and bonds that work financially and that you can live with when the tough times come – and they surely will.

Indeed, this bull market is long in the tooth and reasonable people would have expected a correction or even a bear market (a 10 and 20 percent decline respectively) at some point in the last five years.  I don’t know when it will happen, but a market decline is inevitable, even normal.

Down markets are part of stock investing, so while markets are high, do yourself a favor and make sure you’re comfortable with your asset allocation now.