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With the holidays fast approaching, I am reminded of bubbles and how they affect us. Most people like bubbles. In fact, we are exposed to them almost daily. Most of us rely on them to help us celebrate special occasions and events (popping a champagne cork or having a toast).

Young children are particularly fascinated with bubbles. They love to blow them at parties and then chase them as they magically float into the sky. Of course, these bubbles never really get very far. Many are popped by the children; others simply pop on their own.

Adults are fascinated with bubbles, too. This is especially true of financial-related bubbles. Even if you weren’t chasing the recent housing bubble, many of you were likely keeping score and had fun watching the value of your home climb to unprecedented heights. Before this, history reveals a litany of bubble-chasing that started well before there were internet stocks, gold bugs, Japanese equities, radios, automobiles, railroads, or even tulip bulbs.

Much has been written about bubbles. The book Manias, Panics and Crashes by Charles Kindleberger is one of the better known works. In it, he describes the pattern that many financial bubbles follow:

Displacement. Bubbles start with some grounding in reality. In this phase, smart early investors notice important changes and start investing. Some make a killing.

Boom. Before long, a convincing narrative emerges and becomes self-reinforcing. In the 1920s, people thought cars, radios, refrigerators would change the world (they did). In the 1960s, it was electronics. In the late 1990s, the internet. In the 2000s, easy lending.

Euphoria. Soon, the masses can’t resist. In Kindleberger’s words, “There is nothing so disturbing to one’s well-being and judgement as to see a friend get rich.” Unfortunately, this phase tends to be brief and rarely ends uneventfully.

Crisis. Those in the know start selling first. When selling gains momentum, euphoria is replaced by panic.

Revulsion. Prices then overshoot on the downside. People and media seek scapegoats: Enron, AIG, Madoff, instead of blaming themselves for participating in the bubble in the first place.

Perhaps you think I’m raising awareness of this because I believe we are in a bubble. The reality is: I don’t know. No one does. I do worry, however, that the U.S. and European central banks have become ‘bubble machines.’ These institutions have a vested interest in propping up our economies and keeping interest rates artificially low so the burdens of excessive debt don’t crush us. In the process, prudent savers and cautious bond holders are being punished, while those who take increasingly big risks are being rewarded.

While I would expect ever-rising U.S. stock prices to stimulate ‘equity bubble’ refrains, I’ve been struck by the growing number of pundits just now jumping on the ‘why stocks are undervalued’ bandwagon. As a result, we may be seeing evidence of tiny bubbles and this has us at HoyleCohen on bubble watch.

Bubble watching can be a long, tedious sport. I recall former Federal Reserve Chairman Alan Greenspan pondering whether ‘irrational exuberance’ had unduly escalated asset values in the 1990s. Ironically, he used that phrase on December 5, 1996 when the S&P 500 closed at 744. Had someone used that as a signal to sell equities, they would have missed out on a more than doubling of the S&P 500 in the ensuing three years. Of course, we also know now that the S&P 500 approached this 1996 level in October of 2002 and dropped below it in March of 2009.
Where this might lead or how this might end, no one can predict. No modern investor has seen these forces at work and as a result, they can confound rational thinking for longer than people realize. I’d like to believe these so-called experts. Perhaps I would if I felt it was the dawn of a new “Golden Age.” However, a backdrop of record debt, slow growth, and stagnant income doesn’t feel like it.

This is not to say that we (or you) are not poised to benefit. As you know, our investment platform is designed to participate in additional upside; but, it also places a strong emphasis on mitigating downside risk and securing prior gains. Einstein said, “The difference between genius and stupidity is that genius has its limits.” The more I see above-average returns, the more my intuition and experience guide me toward caution, not risk-taking. When and how this caution will be rewarded, I don’t know.

We are on ‘bubble watch’ and will try not to be lulled into a false sense of security regarding risk and reward. Instead, we will remain vigilant and resist the temptation to chase.
May you enjoy the upcoming holidays and the bubbles offered you without worry.

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