There are two aspects of asset bubbles that are of great importance.  The first is the impact such bubbles have on investors.  The second is what impact these bubbles have on the overall economy.

It should be noted that asset bubbles are often widely seen as attractive and/or beneficial during their expansion phase.  For instance, during the housing bubble, few people were wary of the “bubble” trend; in fact, the vast majority – including professional economists and policy makers – thought such price appreciation was “great” (i.e. highly beneficial), and such appreciation was “natural” as opposed to constituting a “bubble.”  The vast majority also believed such house price appreciation would last indefinitely, with few risks posed.  Exceedingly few (especially on a percentage basis) predicted the “top” of the bubble or the economic ramifications of its aftermath.

My analysis continues to indicate that the peril presented by the current asset bubbles can’t be overstated.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1314.53 as this post is written

During the recent market tumult, bond yields have once again dropped sharply to very low levels, as seen by the yield on the 10-Year Treasury.  A couple of charts illustrate this.  First, a weekly long-term chart from 1962 as seen in Doug Short’s August 12 blog post titled “Treasury Yields in Perspective“, with 10-Year Treasury Yields shown in blue:

(click on chart to enlarge image)

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Next, a 3-year daily chart of the 10-Year Treasury Yield:

(click on chart to enlarge image)(chart courtesy of StockCharts.com)

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While this Bond Bubble may have a little more “upside” left to it, I am of the belief that attempting to derive gains from bonds at this point is akin to “picking up pennies in front of a steamroller” – i.e. there is little to be gained, and much to be lost.

While the Bond Bubble continues, its risks to investors, financial markets and the economy in general has in no way diminished.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1194.20 as this post is written

While I don’t agree with many of her points and assertions, I nonetheless think the topic is very important.  As such, here are a few excerpts that I think are notable:

page 1 :

Monetary policy in the United States has been highly accommodative now for a number of years.  Since late 2008, the Federal Open Market Committee (FOMC) has kept the target federal funds rate close to zero and has purchased a substantial amount of longer-term Treasury and agency securities.  My reading of the evidence is that those securities purchases have proven effective in easing financial conditions, thereby promoting a stronger pace of economic recovery and checking undesirable disinflationary pressures.  Moreover, I believe that the current accommodative stance of U.S. monetary policy continues to be appropriate because the unemployment rate remains elevated and inflation is expected to remain subdued over the medium run.

page 2:

In the aftermath of the crisis, the primary objective of U.S. monetary policy was to promote financial conditions likely to spur spending on goods and services through a number of channels.  To this end, the Federal Reserve first lowered the federal funds rate and other rates at the short end of the yield curve and, once the zero lower bound was binding, sought to push down yields at the longer end through large-scale purchases of longer-term Treasury and agency securities.  We anticipated that lowering rates on these securities would place downward pressure on a range of private yields as well, in turn supporting home values, equity prices, and other asset prices.  After all, this is the primary mechanism through which monetary policy in its conventional form stimulates the economy.  But a sustained period of very low and stable yields may incent a phenomenon commonly referred to as “reaching for yield,” in which investors seek higher returns by purchasing assets with greater duration or increased credit risk.

page 4:

Misaligned asset prices are notoriously difficult to detect in a timely fashion, and no single metric or set of metrics can consistently and reliably identify stretched valuations.  Nonetheless, it is clearly worthwhile to track a wide range of metrics and to view them in the context of their historical norms.  Current conditions can be evaluated against a baseline of past experience, and then assessed in light of the various institutional and market factors that could conceivably account for deviations from historical ranges.  The Federal Reserve tracks a large number of indicators, and I will highlight a few examples.  Overall, these indicators do not obviously point to significant excesses or imbalances in the United States.

page 8:

Therefore, the risk of a rapid and disorderly deleveraging in the event of a swift change in market sentiment seems to be limited at this point.

page 8:

First, important classes of generally unlevered investors (for example, pension funds) are reportedly finding it difficult in the present low interest rate environment to meet nominal return targets and may be reaching for yield by assuming greater interest-rate and credit risk in their portfolios.

page 10:

If substantial evidence of financial imbalances on a broader scale were to develop, particularly if accompanied by significant use of leverage, I believe that supervision and regulation should constitute our first line of defense.  Indeed, in the wake of the crisis, our supervisory process has been significantly modified to take more explicitly into account possible financial stability implications and effects on the broader economy, a perspective that is frequently described as “macroprudential.”  Our concerns now extend beyond the capacity of individual institutions to protect their capital and balance sheets.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1279.56 as this post is written

In that post I highlighted a variety of factors that support my conclusion that the entire stock market is experiencing a bubble.

One of the factors listed was “Extremely rapid valuation increases seen in a variety of private (tech) companies to high valuations, despite any clear indication that fundamentals have changed proportionately.”

Since the writing of that post, we have had one very notable IPO, LinkedIn, as well as another pending IPO, Groupon, that serve to illustrate that point.  What is notable in many of the private tech companies’ valuations includes the current size of the valuations; the size of the valuation increases; and the rates at which the valuations are increasing.  All three of these aspects are (very much) outsized.

LinkedIn’s first day of trading, May 19, likely reminded some of the type of manic price action seen during tech IPOs of the late ’90s.  Here is the chart from May 19 in 1-minute increments:

(click on chart to enlarge image)(chart courtesy of StockCharts.com)

As seen in Barron’s, May 23, in an article titled “Is LinkedIn Already Tapped Out?” at a price of $93 the Market Capitalization was $8.7 Billion and 2010 Revenue was $243 million, with 2010 Profits of $15 million.  As seen in the article, “Twenty-seven months ago, LinkedIn was issuing options with an exercise price of just $2.32 – less than 1/40th of what investors paid last week.”

The Groupon jump in valuation is starkly illustrated by the following, as seen in a Wall Street Journal June 3 article titled “Groupon to Gauge Limits of IPO Mania.” From that article: “As of March 31, Groupon’s shares traded among institutional investors in private secondary trading at an implied valuation of $5.6 billion, according to Nyppex LLC, an intermediary in the secondary market.”

While Groupon has yet to go public, various sources have been predicting a resulting post-IPO Market Capitalization in the $20-$30 Billion range.  One revenue projection indicated 2011 revenue of $2.6 Billion.

I could write extensively about my thoughts concerning the fundamentals of both LinkedIn and Groupon; for now I will highlight one item (among many) that deserves particular attention – that of the outsized Price-To-Sales ratios.

Of course, there are many other private tech companies experiencing similar dynamics.  In aggregate, these huge, fast jumps in valuations – to (very) high valuations – should serve as a “red flag” that there is wildly excessive positive sentiment.

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The Special Note summarizes my overall thoughts about our economic situation

SPX at 1283.31 as this post is written

First, per my last two posts, my analysis indicates the entire stock market is currently a bubble.   Given that conclusion, as well as my opinion that there are various other asset bubbles in existence right now, I would like to highlight a post I wrote on May 27, 2010 titled “Bubble Investing.”

Second, I view the stock market as exhibiting characteristics of a “crowded trade.”  I recently wrote of this condition on February 28 in “The Stock Market as a ‘Crowded Trade’.”

A Special Note concerning our economic situation is found here
SPX at 1308.44 as this post is written

There are various aspects of the stock market that lead me to conclude that the stock market is experiencing a bubble.

First, for reference purposes, here is a 1-year daily chart of the S&P500 updated through February 28, 2011:

(click on chart to enlarge)(chart courtesy of StockCharts.com)

Here is a list of various general areas that, in total, I believe support the conclusion that the stock market is a bubble :

• Exceedingly strong price action; by many measures this rally is among – if not – the strongest in history
  • This is seen in the price chart of the S&P500 – as well as many individual stocks – as an increasingly “parabolic” trajectory, especially viewed from September 2010 to present
• A high degree of “froth” – Although difficult to prove, “froth” is often seen during the terminal stages of asset bubbles
• Excessively high sentiment – Among established, quantifiable sentiment measures, this stock market has been displaying prolonged periods of excessive sentiment readings
• Extremely rapid valuation increases seen in a variety of private (tech) companies to high valuations, despite any clear indication that fundamentals have changed proportionately
• The stock market seems to have the “feel” of a self-feeding mania, which was seen in other recent bubbles such as the NASDAQ and Internet bubbles of the late-90s, as well as the housing bubble
• Proprietary measures that I keep that show vast overvaluation
• A general attitude of “nothing bad can happen” – often the low interest rate environment and strong intervention policies such as QE2 are quoted as “guarantees” precluding any substantial adversity

I have repeatedly stated, since my June 2, 2010 post, that I believe the stock market will continue to rise despite highly problematical future conditions in both the stock market and overall economy.  While I still think it will continue to rise, at this point I feel that it is becoming an increasingly (very) high-risk proposition to hold long equity positions.  This is especially so given my certainty that there will be an exceedingly large stock market “crash” in the future, of which I have previously commented upon.

A Special Note concerning our economic situation is found here
SPX at 1327.22 as this post is written

I would like to elaborate upon my reasoning for such, especially since it is a view (admittedly) held by very few.  What makes this stock market bubble particularly insidious is that by many outward appearances it doesn’t appear to be a bubble.  The most deadly bubbles are ones that don’t obviously appear as such.

I believe that the subject of bubbles, and determination of such, is a very complex, yet critically important subject.  As such, I have written extensively about them in the context of our present economic situation and their impact on future economic prosperity.

Perhaps adding to this complexity is that there really isn’t a concrete definition of what constitutes an asset bubble (or “speculative bubble”).

For many of these reasons, “spotting” and identifying bubbles – especially while they are  “in the making” – can prove difficult.  As I commented in my post of December 2, 2009:

“Some bubbles are harder to spot than others.  Bubbles, almost by definition, include irrational behavior, and therefore can be hard to predict both in their formation as well as their ultimate size.  There are many factors that can come into play in order to cause bubbles.”

I view the process of identification of bubbles into two components; fundamental analysis and technical analysis.  The fundamental case that the stock market is a bubble ranges from relatively simple to vastly complex;  as such, I will (at least for now) primarily focus on some of the technical analysis (and other price movement) issues that are of a more straightforward nature.

In my next post I will elaborate upon these factors…

A Special Note concerning our economic situation is found here
SPX at 1328.68 as this post is written

Although I continue to believe the stock market will go higher, there are many technical and fundamental signs that are disconcerting.  I will be discussing these in detail in the near future.

Another issue of great importance is whether the stock market, as a whole, is currently a bubble.  I believe that it is.  This is admittedly a very unique opinion.  I will discuss my reasoning in a future post.  This “bubble” condition will have immense future ramifications.

For reference purposes, below is a daily chart of the S&P500, from March 2, 2009, near the March 6, 2009 low of 666.79:

(click on chart to enlarge image)(chart courtesy of StockCharts.com)

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A Special Note concerning our economic situation is found here

SPX at 1321.87 as this post is written

As I have previously written, I believe that there is a bond bubble encompassing the entire bond market.  While for many reasons one might not expect the bond market to become a bubble, nonetheless such a bubble has occurred and it is now simply enormous.  This bond market bubble stands out from other bubbles in history in both size and duration.

As one can see in the chart below, from Doug Short’s site on 10-4-10, the 10-Year Treasury Yield (blue line) has been on decline since the early ’80s:

click on chart to enlarge image

This decline in bond yields has been exceedingly munificent to the economy in many different ways.  As well, the bond bubble has been very beneficial to a range of asset classes.   On the above chart, one can see the performance of the S&P500 in green during this period of falling interest rates.

Of course, if one believes the bond market is a bubble, then a pivotal question becomes when will the bubble “pop?”  This question is difficult to answer, as there is a complex interaction between various factors fueling this bubble.

One important factor is that of additional Quantitative Easing (QE).  Many believe that such efforts will further depress interest rates.  Various estimates seem to generally support the idea that $2 Trillion of additional QE would depress 10-Year Treasury rates (currently at 2.48%) by approximately 100 basis points.  While I believe that such an effect may be possible, it is likely such an impact is overstated.

For many reasons, it is tempting to conclude that the bond bubble will last for years.  In fact, I am not aware of anyone who is predicting its imminent demise, i.e. “popping.”  However, I believe, from an “all things considered” basis, that the “popping” of the bond market will happen in the short-term (i.e. likely within 6 months, and possibly even yet in 2010).  I make this judgment based upon many different factors.  Such a bursting of the bond bubble will have immense ramifications on many levels; I have already discussed the threat of rising interest rates in an April 6 post.

Another critical issue with regard to the bond bubble is the following:  If one believes that there is a bond bubble that is serving to unduly depress interest rates, what might be the “natural” interest rate – i.e. one that may endure after the bond bubble pops?  I may discuss this, as well as further define the timing of the bond market “top”, in future posts…

A Special Note concerning our economic situation is found here

SPX at 1137.03 as this post is written

“When you live in a bubble, everyone is delusional…” -

-Nouriel Roubini, May 11 2010 Charlie Rose interview

Many people fail to see any asset bubbles in our current economic environment.  Others see isolated asset bubbles.  As I have previously stated in the April 8 post,  “Our societal inability to spot and prevent asset bubbles is problematical.”

I have written extensively about the existence of asset bubbles.  The topic is of critical importance as their widespread existence precludes the possibility of Sustainable Prosperity.

A Special Note concerning our economic situation is found here

SPX at 1109.55 as this post is written