If you are not familiar with "tulipmania" as the story was popularized in Charles Mackay's 1841 book, Extraordinary Popular Delusions and the Madness of Crowds, you should be. It is one of the most important lessons that any investor should be aware of.
In the early 1600's in Holland a man of means had to collect tulips or be considered totally devoid of good taste. Rare species of tulips were in high demand as the rich sought to impress their friends.
It was not long before the status of owning tulip bulbs caught the attention of the middle class. Even those of modest means wanted to own tulip collections. As demand increased, prices increased. As prices increased, many people made money. As more people made money, many more people wanted to share in the wealth and tulips seemed the easiest way to do it. There is no greater motivator than greed. And nothing that makes one greedier than to see their neighbor become rich.
At the peak of Tulipmania, it was not uncommon for a single tulip bulb to sell for ten times the annual income of a skilled craftsmen.
Of course, the bubble burst. As more and more got in on the tulip investment there became fewer and fewer people that wanted to buy tulips. Slowly, and then suddenly, people came to their senses. After all, it was just a tulip bulb and they needed money for food, shelter and clothing. There were no more buyers, just sellers. The price on some bulbs dropped to 1/100 of its previous value in a matter of weeks.
It is easier to get people to understand "bubbles" today because many experienced the dot.com stock bubble in the late 1990's and almost everyone has seen the effects of the housing bubble of the 2000's. However, we could be living through one of the largest investment bubbles of all time right now and very few seem to be aware of the danger. I am speaking of the bubble involving sovereign debt securities. We all know that Greece, Spain and Italy are in trouble. As a result, investors want to avoid the debt of these countries but they are pouring money into the debt of other countries out of this fear.
Bonds of countries like the UK, Japan, Germany, France and the U.S. Does any of this make sense?
Grant Williams writes an excellent weekly missive called "Things That Make You Go HMMM..." He sees all of this activity as something similar to a Pavlovian response on the part of investors. They are conditioned to run to safety in bonds when there is trouble. However, are they really running away from trouble this time? The debt of the countries they are buying are also countries that have their own fiscal challenges and will also likely have to bail-out the weaker players to avoid a total financial worldwide meltdown.
How does this make any sense? It doesn't according to Williams. Consider the U.K.
The U.K. Treasury has been issuing "gilt bonds" for centuries. The U.K. government has never been able to borrow money cheaper than it can today. That is NEVER. Going back to 1750 based on this chart that Williams sourced from Thomson Reuters/Credit Suisse.
Britain's budget deficit is 8.24% of GDP. Its debt as a % of GDP is almost 90%. Does this look like the profile of a country that should command a current 5-year bond interest rate of .704%? That is 7/10 of one percent. A level not seen in over 250 years of U.K. history! I don't think so.
Germany is in better fiscal shape than the other countries we are talking about. However, Germany is the lender of last resort for all the other European countries. What are they going to look like if they have to pay the debts of a good part of the rest of Europe? How does Williams see all of this?
The biggest bubble in the world right now (apart from that in political incompetence) is the sovereign bond market and the bubble has inflated for PRECISELY the same reasons that all other bubbles do—investors stampeding into an asset without thinking about the underlying dynamics of the instrument they are buying. Often it’s based on greed; this time it’s based on fear. The outcome is the same in both cases I am sorry to say. It was ever thus.
To illustrate the point, let’s return to Germany and imagine you invested €1mm into 2-year bunds today. At the end of your 2 years, you would receive back from the German government €1,008,618.49. Pretty good, huh? Nobody ever got poor making a profit, right?
Well let’s see.
On the day you received your money back from the German government, a basket of goods that would have cost you €1,000,000 today will cost you €1,052,676 (assuming Eurozone CPI stays constant at 2.6%).
How’s that $8,618.49 profit looking now?
Although people are looking for safety in these sovereign debt instruments they can be anything but safe if yields rise. For example, if a 3% 30-year bond moves to a 5% yield, the investor will lose 30% of their principal. If long term bond rates move from 3% to 7%, they will lose half of their money.
What about U.S. Treasuries? Roben Farzard of Bloomberg Businessweek provides some historical perspective.
Marinate your mind in this for a minute: Long-term U.S. Treasury yields are essentially at a 220-year low, says Barry Ritholtz. Mind you, 1792 was when two dozen brokers met under a buttonwood tree in Lower Manhattan to shake hands on what would ultimately become the New York Stock Exchange. And when George Washington, while test-driving his second set of experimental dentures, cast the nation’s first presidential veto. And France first successfully used its guillotine. Those 220 years traversed at least three panics, two depressions, two world wars, multiple global economic crises, a Great Recession, and “Who Shot J.R.?”
All that history be damned; on Thursday (May 31) the 10-year Treasury touched a record-low yield of 1.5309 percent. Thirty-year bonds, for their part, fell to a yield of 2.6 percent, which is just above the all-time low they set in the midst of the Panic of 2008. Apparently our times are so fraught with fear and the need to flee to safety that the Treasury market is pricing in historic amounts of misery. As the Wall Street Journal’s Dennis Berman tweeted, “Even in ancient Babylon (4%), Medieval Europe (6%), 1800s America (4%), no one was paying 1.6% for 10-year money.”James Bianco provides this long term perspective on 30-year bonds back to 1790 in the United States. Again, we are very close to 220 year low interest rate yields.
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| Source: Bianco Reseach |
Grant Williams puts it pretty simply in his conclusion.
At some point—and I suspect that point will arrive sooner rather than later—intellectual reasoning will overcome Pavlovian conditioning and the same people who poured trillions into the debt of bankrupt and irresponsible governments will realise the folly of their instincts and they will go looking for a real safehaven asset. When they do, they will find that, unlike government debt which, like a gas, can expand to meet any demand, trying to hide trillions of dollars in a real asset such as gold (or farmland) will prove to be singularly difficult.
Those overcoming their Pavlovian conditioning and allowing intellectual reasoning to win out first, will find themselves at a tremendous ad- vantage once reality is forced upon the masses. That day is rapidly approaching.
Buyer Beware of the bond bubble!
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