GOGGLE BUBBLE. This is a suggestion, not stock analysis.

A Goggle Search of “bubble” only take four entries to get beyond the eponymously named kids gum to a topic dear to our investing egos, “economic [financial] bubble”.

Recent bubbles were the “dot.com” bubble, various real estate bubbles, and the Japanese asset bubble of the 1980s and early 1990s. Some famous past bubbles include the tulip bulb bubble of the 16th century, the South Sea bubble of the 17th century, the railroad bubbles of the 19th century, and the stock market bubble of 1929. Bubbles, historically, have moved from place to place and time to time. But they all work about the same. An asset class skyrockets in price as it is bid up by irrational exuberance, greater fools, and booming idiots.

WE HAVE HEARD IT BEFORE, “IT’S DIFFERENT THIS TIME.” BUT IS IT DIFFERENT IN A DIFFERENT WAY?[i]

Sure, the Author rides slower lap times. But he knows where to go to buy some extra horsepower or fine tune the suspension. And he studies the leaders and the podium finishers for tips to up his times. (Okay, enough motorcycle metaphors.)

Jeremy Grantham is a principal in the investment firm of GMO LLC. Mr. Grantham is a keen observer of world asset markets and “fair values” of such assets. The May 2006 Desert of the Real newsletter discussed some of Mr. Grantham’s observations.

In Mr. Grantham’s quarterly letter of April 2007, “It’s Everywhere, In Everything: The First Truly Global Bubble”. Mr. Grantham observes that all three major asset classes, real estate, stocks and bonds are expensive relative to their price histories and replacement cost.

Mr. Grantham further states in the April 2007 letter:

The necessary conditions for a bubble to form are quite simple and number only two. First, the fundamental economic conditions must look at least excellent – and near perfect is better. Second, liquidity must be generous in quantity and price: it must be easy and cheap to leverage. If these two conditions have ever been present without causing a bubble it has escaped our attention.

BUT THERE IS MORE…

Further, the Grantham Newsletter states that as of May of 2006, the risk premium difference (investors that take more risk on their investments demand a higher return between GMO’ low risk and high risk portfolio was .08%. In September of 2002, the differential was 6.4%.

Let’s put it another way. Risk, or the chance (percentage) that the financial gain or loss we expect will vary from a large gain to a large loss, is condition where rational investors demand a risk premium. To illustrate, let’s look at two portfolios;

One is the Widow’s and Orphan’s Fund. It invests in high-grade bonds and blue chip stocks. Its returns are not stratospheric, but year in and year out the Fund generates solid returns. Widow’ and orphans need these low volatility results to eke out a modest lifestyle. The Risk of the fund, based upon annualized volatility is 4%. So this means that the annual results are historically within a 4% range. Lower risk of worse results but lower risk of better results.

The other fund is the South_Sea_Tulip_Genome.com Fund. It invests in biotechnology and Britney Spears Commando Shot futures. Prize Alert [ii]. These are high risk investments and the annual results have a volatility of 15%. Wide swings for wide swingers.

IF EVERYTHING IS OVERPRICED, WHAT SHOULD YOU OWN?

The short answer is nothing. Or nothing but cash. The current 3-month Treasury Bill is returning about 4.76%. But remember that the Author’s investment methodology is a momentum-based, relative strength approach. If the indicators the Author follows are moving up, that’s where he is. More on that in another post, but the Author has large holdings in international equity and international emerging equity markets. And tight stop loss orders.

But it is important to understand asset valuations because sooner or later (what a dodge), the means-reverting mechanism of the markets will burst the bubble and bring asset prices in line with asset value.

BUBBLES COME, BURST, AND COME AGAIN. KIND OF LIKE STARLETS AND POP SINGERS. FROM THE DESERT OF THE REAL.

IMPORANT DISCLAIMER: This Blog is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.

i. The phrase “It’s Different this Time” usually precedes a bubble burst. But if all assets are overpriced, that is some difference.
ii. PRIZE ALERT! The first reader that can tie this obscure yet risqué pop culture reference to the financial future’s market will win a prize. The winner can choose from a ticket and a soda at the Guild Cinema in Albuquerque, a plate of the best huevos rancheros in Albuquerque at the Central Avenue Village Inn, or a gift certificate for $10.00 at a restaurant of the winner’s choice. Email your responses to: desertoftherealeconomics@hotmail.com.