Bubble Bubble Toil & Trouble

The title of this post was going to be “Financial Media Pet Peeve #342” but I can’t resist a Shakespeare reference, especially since we’re only a bit past Midsummer’s Eve.

Anyway…

If you consume any financial media whatsoever I’m sure you’ve seen article after article saying that the stock market is in a bubble, totally disconnected from fundamentals, and that it will end in tears. One hilarious article interviewed a guy who got burned trying to short the market back during the dotcom craze and said what we’re seeing now is even worse.

I hope the irony isn’t lost on him and he’s not trying to blindly short the market again. Because as he painfully found out last time, just because you think a business or market is disconnected from fundamentals doesn’t mean it can’t keep going up. Some businesses, like Tesla, you either just fundamentally misunderstand or there’s a core of fanatics that buy at any price. Other businesses, like Wirecard, appear fraudulent, get called out repeatedly for 12+ years by various short-sellers, and yet still go up in price for more than a decade as they build actual businesses onto a shady core. And then you have mass hysteria. The type of buying that drives whole markets higher and seemingly disconnects them from any sort of fundamental reality.

A Tale of Two Yields

The issue is that the investment world, much like negotiations, is an exercise in analyzing your next best alternative. To reduce this to an absurdly simple level, imagine your choice is between IEF and SPY. IEF’s 30-day SEC yield is 0.5 percent and the only possibility of gaining more than that is if yields drop further. It’s possible, but the Fed appears to be holding strong at the zero-bound and currently prefers to use direct market intervention in the bond market instead of setting official Federal funds rates below zero.

Compare this to SPY, which has a 1.85 percent yield. If you use prior recessions as a guide, you could reasonably expect SPY’s current payout to drop by a third. So base case scenario is a ~1.2 percent yield based on current prices with the possibility that it rebuilds to prior levels. The downside case is that a one-third drop in SPY’s yield probably comes with quite a bit of price volatility.

Sophie’s Choice

Sorry, this is the worst literary pun I’ve made yet (today!). Regardless, the difference between the two yields represents the trade-off that a lot of investors are currently willing to make. They’d rather have a 1.2 to 1.9 percent yield plus the potential for upside in exchange for a bunch of volatility instead of locking themselves into an almost-guaranteed 0.5 percent yield for the next 7 years albeit with less volatility.

Alternatively, it may also represent the perceived need of investors to recover lost ground or hit a funding goal (pensions: I’m looking at you). Putting money into SPY, or any equities for that matter, at least provides the investor the chance to make it happen. If an investor puts it into IEF, a CD, or holds it in cash then they’re either relying on a more advantageous opportunity elsewhere or the current anemic yields represent adequate compensation.

Triumph of the Optimists?

In spite of everything that the country is facing, there are still enough people that are optimists and believe the country will be doing better 10 years from now than it is today. I’m one of those optimists: outside of a dramatic acceleration of climate change I don’t see how we’ll be in worse shape in 2030 than we are now.

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