Bank of America Concerned About “Double Bubble”

Bubble

When they look at how much money retail investors are pouring into both stock and bond funds right now, Bank of America is worried that we might be creating a bubble with both.

We use the word bubble to describe situations where prices of things rise so much that they end up collapsing under their own weight, seeing the bubble burst in other words. A great example of this was with the infamous tech bubble burst of 2000, which saw stocks plummet and take quite a while to recover, which we will look at to try to understand what really happened.

The fact that Bank of America has come out and said that they are worried about a bubble being created that may burst with both stocks and bonds is pretty curious, as at first glance you wouldn’t think either is suspect, at least if you understand a little about how bubbles work. Given that these things exist as undefined worries with many investors, it is well worth spending an article on going into this phenomenon a little more as well as looking at what risk there may be out there with this right now, if any.

We know that the stock market does function like a balloon, and it’s not only natural that the balloon gets more air pumped in it over time, we rely on this phenomenon to provide positive returns over time.

The goal here is not to see too much air pumped into our balloon too quickly, because when that happens, it may deflate somewhat. This is not a bursting, it’s a deflation, with the excess air escaping our balloon from what we could describe as its membrane not being able to adjust to the increasing pressure inside fast enough. We push it too far too fast, and this causes some of the air we pumped into it recently to escape back out the nozzle.

This is an important distinction because if we just think of this as the balloon bursting, we’ll just be looking at the volume of air in it and assume that if this gets too big, it may burst. What actually happens has little to do with how much air that is in it, and has everything to do with the level of confidence that a certain rate of growth can be sustained.

To see what this looks like, we only need to look at the tech bubble deflating in 2000, where the Nasdaq rose by an alarming 382% in the year and a half leading up to this. We went from below 1400 to over 5100 in just this short time.

It wasn’t that the Nasdaq’s balloon hadn’t been pumped up a lot to get to 1400, as it opened at 100 back in 1971 and it had grown by 13 times since. Going from 13 times to over 51 times this quickly though ended up being well beyond the capacity of this balloon to take on more air, and over the next 2 years, we gave back all of this 382% and then some, seeing the index return to 2006 levels.

It is notable to point out that at even at the bottom of this move, the running 10-year return for this index was still a decent 92% or 9.2% per year, and that’s if you held though the entirety of this crash and sold right at the bottom. The 20-year return for this index with selling right at the bottom was even better at 29% per year over this period, which tells a story that hardly everyone gets, the fact that good returns can more than offset risk, even the worst kind in this case.

The Nasdaq performed fabulously during the 1990’s, starting the decade at 458 and rising to 5138 at its peak in 2000. People were speaking of the bubble bursting during the last 3 years of the decade, especially during this year-and-a-half crazy run-up leading to the bursting, or more accurately, the balloon undergoing a massive deflation.

Could going up this fast cause this phenomenon though? Plenty of people are happy enough to stop there and write off the gains of 1996-2000 as a flash in the pan and this in itself allegedly had us back to 1996 by the time 2002 came around and the bleeding stopped. There’s no doubt that this meteoric rise contributed to the fall, but these things cannot happen by themselves, they require some sort of negative influence to topple things.

As long as things keep moving up, this will forestall profit taking, as people don’t want to get off the train as long as it keeps moving forward. Without something happening to end the party, it won’t, and the amount of partying we did during that time is testimony to this. A run-up like this cannot cause an event like this, but it sure can add to the magnitude as once the selling really starts, this is when the profit taking really kicks in.

This causes us to fall at a faster than normal rate, and when this happens, people start to panic, and it is this panic that really drives things down. Normally, after a bout of profit taking, even a big one, investors will jump in to buy the dip, but if the dip happens fast enough to start a real panic, there’s nowhere else to go but further down.

We saw this play out in 2000, where we gave back 2000 points in the first 2 months of this, the work of the profit takers, and then made back 1200 of these lost points over the next 2 months. Things started moving down again though, and this time, the dip buyers were simply pushed aside by the mob heading to the exits and this was the real move, and ultimately, we gave back 3000 more points with the Nasdaq.

Several attempts were made to inflate this balloon along the way, and all were quashed, with lower highs and lower lows manifesting, the classic signs of a downturn. All things being equal, the bubble itself cannot fully explain it, as without any intervening force, these things don’t collapse like this by themselves.

We Need to Be Willing to Learn from History

To get a better idea of what actually happened, we need to look back to some previous drops the Nasdaq and see what might have been going on then. The first bear market with the Nasdaq happened in 1973-74, where it lost 60%, a good-sized crash by any definition. We had a little recession going on then, where GDP growth dropped from 5.6% in 1973 to –0.5% in 1974.

We had another recession in 1980, but this one only ended up producing a 22% decline in the Nasdaq, as it was fairly brief. Another little recession popped up in 1982, of similar length and magnitude, which saw the Nasdaq take another 22% dip in the pool. 1990-91 saw another brief recession hit, this time shaving off 30% from the index.

We all know what happened in 2007-2009, where in 2007 the writing was already on the wall and GDP growth dropped dramatically, and then spending both 2008 and 2009 underwater. This one was bigger and badder than these other ones we’ve spoken of so far, resulting in a 54% decline in the Nasdaq by the time it was all over.

Recessions causing drops in stocks is a phenomenon that just about everyone is aware of, and the mere threat of a recession will serve to scare a lot of investors. What is noteworthy about this trip down memory lane isn’t that recessions cause bear markets, it’s that anytime a bear market comes, a significant drop in GDP comes with it. Keeping GDP growth stable is the best remedy against a bear market, with or without a good run-up, and stocks going up is in itself just their doing what they do naturally unless fear enters into the picture enough.

Recessions in themselves have little effect on stocks, other than more people needing to cash in some investments due to job loss. The great majority of the selling that goes on is simply out of fear, but when fear grips the market, being afraid that stocks will go down is a real fear indeed because it is self-fulfilling.

We finally get to the big one of 2000-02, which did have the added element of the big run up and the profit taking that ensued to really get this move down in motion. This, together with unfavorable economic conditions, caused the market to go into free fall.

There’s one key element left to discuss, which is the Fed overcooling the economy with rate hikes. In 1973, they put the rate up from 5.75% to 11%, and the very next year we had a recession. In 1980, it rose to the famous 18%, and the next year we saw another recession. The 1982 one was preceded by a 12% Fed rate.

1988-90 saw the Fed persist in keeping rates high, starting with 9.75% in 1988, and then keeping them high through 1990 which ended up knocking GDP from a little high into the negative. In the lead up to the 2007-09 recession, we went from just 1% in 2003 to 5.25% in 2006, and while they did dial down the rate to 4.25% in 2007 as things started to unravel, the damage was done by then.

It wasn’t the housing market who had their bubble burst in this crisis, it was a credit bubble, and this bubble burst not because housing prices continued to go up, as their stopping going up is what caused things to topple. It wasn’t even the houses that were being bought back then that had much to do with this, it was houses bought back in the days of much lower rates when the Fed rate was 1% but needed to renew at much higher rates that that caused the credit bubble to burst.

Unlike 2000, this one wasn’t a stock market bubble, it was interest rates being too high relative to the circumstances that stifled the economy too much, and with all that bad debt out there, that was just too much. All the bad debt out there at the time did stoke the flames a lot like the run-up in stocks did so in 2000, but in both cases, we had the Fed going way too far and crashing things being the proximate cause.

While the Nasdaq tripled in value from 1998 to 2000, the Fed hiked rates from 4.75% in 1998, to 5.5% in 1999, and finally to 6.5% in 2000. While this did not cause a recession per se, seeing GDP drop from 4.8% to just 1% in a single year as a result of this overly aggressive rate hikes was enough to put a real scare into a stock market that was already quivering from the magnitude of vaulting stock prices, and in fact it was the rate hikes themselves that did the damage as it wasn’t until the next year that GDP took a nosedive.

The Only Bubbles Out There Now are the Imaginary Kind

Fast forwarding to the present time, we have none of these elements going on, and the closest we’ve come to this was the Fed once again being overly aggressive with hikes that caused the market a little scare in 2018, and it wasn’t where the rate was, it was the promise of even more that scared them. Once the Fed told us that they no longer planned on upping rates further, that was enough, and the bulls have been well in control ever since.

To see retail investors putting a good amount of money into both the stock and bond market, a very healthy thing in of itself, as indicative of any sort of bubble or even risk with either market, as Bank of America is suggesting, is a view purely based upon ignorance.

We don’t have anything approaching a bubble in the first place, the economy remains stable and solid, rates are low, and the fear level is very low, given how we shrugged off the coronavirus situation which will shrink the economy for a time at least, more so than the trade war did. China will pay most of the price here, but that also means that U.S. companies will pay a price as well. Aside from the cursory dip when the news hit, with those who scare easily stepping aside, we’ve moved on from this essentially and the skies are blue again.

Since bears thrive on fear, and we have so little of it these days, the forecast right now is unusually calm and bright, not one that is on the brink of any sort of collapse. People investing in stocks again this year on a net basis, where they took out more money than they put in during 2019, is a clear positive, not a negative and especially nothing to worry about.

The idea of it even being possible to have a bubble burst with bonds is simply ridiculous. People never panic with bonds and this may be their sole redeeming feature. Bonds can go down in value and do all the time, and they are remaining strong after peaking last August, but do have a real ceiling and we’re up against a pretty strong one now.

The bubble bursting would involve a mass sell-off of bonds out of panic, but while we see this with stocks sometimes, this could never happen with bonds. This doesn’t mean that there isn’t significant risk in buying them at today’s inflated prices, a little bubble if you will, but this bubble doesn’t deflate very fast or all that much for that matter and the risk here is relatively small compared to what we deal with stocks every day.

Not only is the risk smaller with bonds, but we have the interest that they pay to buffer things, where you subtract these payments from your capital losses to get your net loss. The big knock against bonds is that your money grows way too slowly, but you do get something out of this, a lot less risk exposure if times do get hard.

It would make more sense to say that bonds are around their ceiling, and taking a position at these higher prices presents considerably less upside than normal, and the normal upside is so small anyway. We’ve been saying this for a while now, and this isn’t even something that we need to question because prices can’t stay this high forever. Chances are great that if you buy them here, and you hold them for a reasonable amount of time, you will be selling them at a capital loss, and the interest payments aren’t that good to make sense of such a thing.

There are only imaginary bubbles right now, but it seems that some people in the industry have pretty vivid imaginations, and get caught up in their visions so much that they even fail to look at or even think about what a real bubble looks like to compare.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.