We’re Number 1! The current Economic Recovery has set a record, the longest advance in U.S. history. That’s nice, but the skeptics will immediately ask, when’s the next crash coming? Right now things in the U.S. look good so no immediate panic – but we know that life is cyclical and a recession will happen at some point and the market will decline.
Is there a bubble out there now that will burst when we get that next recession? It was tech in 2000 and housing in 2008. My vote for the next Bubble is ‘stretching for return; or taking on too much risk to get added return.’ It is only natural when bond rates are low and asset prices are above average to try to sneak in extra return while keeping a blind eye to risk.
Two examples: Professional pension and endowment managers have shifted away from meat and potato stocks and bonds in favor of alternative investments. First it was hedge funds, but their fees are high and their performance was disappointing. Now its Private Equity (PE) which borrows at ultra-low interest rates to take small to mid-sized companies private. Management and the product line are tinkered with, profits are spiffed up and the companies are brought back public at a healthy if not obscene profit for the PE firm. This all works as long as interest rates and the cost to buy companies are low. But as money has piled into this trade, target companies have gotten more expensive and in a recession, the PE model may be a bubble in waiting. Everyone today is trying to copy the ‘Yale endowment strategy’ of substituting alternative investments for traditional stocks and bonds but not everyone can squeeze through this door.
A second example is corporate debt. Over half of all corporate bonds today are rated BBB which is just one tick above junk. The difference in yield between highest – quality U.S. Government bonds and junk is low today, meaning investors don’t see much risk in buying low rated debt. So far the bet has paid off, but what happens in a downturn when more bonds get downgraded, when defaults increase and wholesale selling of bad debt ensues? Again, maybe a bubble in the making.
Bubbles are always easy to identify after the fact but not so easy to decipher in real time. As the old Stock Market adage goes, “there is room for Bulls and room for Bears but no room for Pigs.” Stretching for return often comes back to bite you.