Bubbles are Plentiful in the Investment Markets


Experts are seeing signs of bubbles in stocks, bonds and farmland.  This froth is basically the result of the Federal Reserve’s policy of credit easing – implemented primarily by its purchase of Treasuries and mortgage securities, which lowers interest rates and drives investors into riskier assets.

The Fed’s primary reason for doing this is to boost the economy and employment.  With the economy still weak, most Fed watchers believe that there is no imminent threat of Fed tightening.  But Fed bankers themselves, including Chairman Bernanke, are said to be worried that they are creating bubbles in various asset classes that will burst when the Fed begins to reverse its credit easing (“Fed worried about bond bubble: From farmland to junk bonds, officials concerned after buying binge,” InvestmentNews).

Investors in 10-year Treasury notes are paying 54 times the interest payments to hold the notes, the highest since the 1920s, according to the article.  By contrast, the Standard & Poor’s 500 stock index is selling for just 14.8 times earnings.  Money is flowing into the S&P 500, which has gained 78.1% since 2008, and junk bonds, which have gained 121.8%.

Mr. Bernanke is evidently concerned enough about asset bubbles that the central bank has “increased enormously the amount of resources we put into monitoring financial conditions.”  That includes a new Office of Financial Stability Policy and Research to conduct financial system surveillance and the Large Institution Supervision Coordinating Committee to look for risks in the largest financial institutions.  Mr. Bernanke reportedly considers them to be “the first line of defense against asset bubbles.”  Others believe that the bubbles already exist and are just waiting for the end of credit easing to contract.

It is believed by many that the end of credit easing will cause significant price declines in all classes of riskier assets, not just bonds.  In addition, many believe there is little chance of the Fed negotiating a “smooth landing.”  As one senior U.S. economist put it, the Fed may try to avoid creating market instability by pulling back gradually, but he believes that will not work, because the market will immediately discount bond prices based on the Fed’s entire portfolio, as if it was sold into the market all at once instead of gradually.

As always, financial advisers should use prudence and caution in advising investors amidst the uncertainty and potential for instability.

Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.