Bubble Bath?

Anyone who started out 2013 with a case of triskaidekaphobia (fear of the number thirteen) was likely to have ended the year with triskaidekaphilia unless, of course, they were of the ursine persuasion. The Dow Jones Industrial Average soared almost 27% before dividend reinvestment - an impressive achievement given all of the uncertainty about monetary and fiscal policy and an economy that looked fragile at best through much of the year. Then again, the hoary adage that “bull markets climb walls of worry” encourages one to wish for more of the same in the coming year.

Alas, the glad tidings did not extend to most other investment arenas. The precious metals were the mirror image of the stock market as gold suffered its largest decline (-28.7%) since 1981 and silver plunged 36.6%. Commodity prices in general were down for the year as the CRB Index fell five percent. There were exceptions, however, as crude oil prices registered modest gains. Copper prices, while down for the year as a whole, were able to hold above critical support at the $3.00 level and stage a rally in December.

In the fixed income sector, Treasury yields rose across the board as bond prices fell in anticipation of stronger economic growth and an end to the Fed’s massive stimulus program. The high yield sector, however, took its cue from the roaring stock market and posted modest price gains as yield spreads dropped to near record low levels.

After rather feeble growth in the first half of the year, real GDP spurted 4.1% (annual rate) in the third quarter. The stronger growth appears to have continued into the fourth quarter albeit at a somewhat slower pace due to the government shutdown in October. Auto sales were the strongest since 2007 and housing activity continued to move erratically higher.

The most critical component of the economy - the jobs market - also showed growth but at a pace that is not consistent with 3% GDP growth, much less 4%. Non-farm payrolls gained a little over 200,000 in October and November - a level more in keeping with GDP growth with a 2% handle. The most sensitive

indicator of employment conditions - weekly new claims for state unemployment insurance benefits - was quite volatile during the fourth quarter. The influence of the shutdown was apparent when claims spiked to the 370,000 level in October after beginning the quarter at 300,000. Following the shutdown they dropped temporarily below 300,000 before moving back up again to around 340,000.

If the economy has truly moved to a higher rate of growth, claims should fall back to and below the 300,000 level in the coming weeks. If that does not occur, we would expect first quarter GDP growth back in the 2% area.

Although inflation, as measured by the CPI, remains below the Fed’s purported target rate of 2%, the central bankers nonetheless elected to start tapering the monthly purchases of government and mortgage-backed bonds from $85 billion to a mere $75 billion. Hence, the rehabbing economy is going to go through a measured withdrawal rather than a regimen of cold turkey. We suspect that it will take a year or more for the Fed to reduce the bond purchases to zero. Meanwhile, wonder of wonders, Congress passed a budget and the President signed it. No doubt said budget does very little to address long-term problems but, hey, this is the first sign of cooperation since Ronald Reagan and Tip O’Neill got together for cocktails back in the ’80’s. It must have been the holiday eggnog this time around.

In the Sporting News, the Titans failed yet again to make the playoffs and, along with several other NFL teams, decided to fire their coach. Mike Munchak, however, needn’t be overly concerned about long-term unemployment. NFL coaches play a continuous game of musical chairs and fired coaches always seem to pop up somewhere else in short order. In the college ranks, the formerly hapless Vanderbilt Commodores, however, have a different problem. After back to back nine-win seasons for the first time in history, it seems that just about everyone is after their coach. 

In science news, it turns out that Chicken Little was right. A large bolide (meteor) exploded over Russia last year causing multiple injuries from broken glass. While NASA and others have identified thousands of Earth-orbit crossing asteroids (very large space rocks) similar to the one suspected to have led to the extinction of the dinosaurs, there are millions of these smaller sized rocks out there that could hit us at any time. We expect legislation any day declaring the planet’s surface to be a Hard Hat Area.

What do Ben Bernanke and the late Don Ho have in common? They share an affinity for the tune, “I’m forever blowing bubbles.” Well, okay, so the actual name of the song is “Tiny Bubbles.” That might have been okay for Mr. Ho but Mr. Bernanke did things on a much larger scale during his tenure as Fed Chairman.

Lately there has been a growing debate about whether the stock market is at or approaching bubble status, a debate no doubt fueled by last year’s outsized gains and the fact that the Dow, for example, is up 155% since the low in March of 2009. The bulls, on the one hand, suggest that current valuation levels are not excessive based on historical averages. The bears point to sentiment indicators that are at or near record bullish levels. Contrary opinion, in their view, would imply that a substantial correction should ensue.

Sentiment indicators reflecting the opinions of market analysts hold little currency with us (to paraphrase Grouch Marx, I wouldn’t want to belong to a club that would take me as a member). We are much more persuaded by data based on where one puts one’s money. Along these lines one of the most troubling indicators is the all-time record high level of NYSE margin debt. Bubbles require air and debt is a vehicle for producing a lot of air. It has equal puissance as a vehicle for deflation. Hence, with equity prices being supported by an enormous amount of debt, there is at least a risk of a rapid deflation of stock prices.

Stocks, moreover, are not the only asset class to have attained record levels:

The Scottsdale and Monterey classic car auctions totaled a record $535 million in 2013 (the 2003 total was $73 million);

A 59.6 carat pink diamond sold for a record $83 million; Two NYC taxi medallions sold for a record $2.5 million;

France’s oldest charity wine auction raised a record $6.8 million;

A record $474,000 was paid for a case of red burgundy wine (that equates to $300,000 per gallon, and we gripe about $4.00 gasoline).

We could go on and on but feel assured that the reader has gotten the point by now.

Hence, while the potential exists for the bubble to burst, it is not clear what might precipitate said bursting. The usual suspect is the Fed, which has a history of following overly generous monetary expansion with overly stringent monetary policy. The rather frothy price gains noted above appear to suggest that recent monetary policy might have been overly stimulative, but what has been a boon for various asset classes has yet to translate definitively to the economy in general. The central bank, therefore, is much more likely to be overly cautious this time around as it begins to rein in money supply growth.

The word “taper” was chosen very carefully. The initial $10 billion cut in monthly bond purchases appears to be a relatively modest step toward reining in credit growth. While the economy can be very sensitive to any kind of change on the margin, the first sign of renewed economic weakness in the months ahead will likely bring an end to or at least a pause in the tapering process. The hope is to let some air out of the bubble in a controlled manner and avoid a puncture that could result in a sudden deflation.

Meanwhile, best wishes for a happy and prosperous new year, and be especially careful around sharp objects. 

- Weaver C. Barksdale, CFA