A Tale of Two Bubbles

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Use Google to search for the term "bond bubble" and you get more than 2 million hits. This isn't terribly surprising, as the past decade has been written by one bubble-and-burst after another. Hit people with enough shoes, and they'll search in angst for the next one to drop.  

Some disagree with this bond bubble talk. But let's assume for the sake of argument that a bubble exists. An important point, then, needs to be addressed. I've always thought there were two types of bubbles: One is a valuation bubble, the other is an income bubble. Distinguishing between the two is extremely important.

Here's the difference.

A valuation bubble is what dot-com stocks went through in the late '90s. With some exceptions, the revenue generated by most dot-coms (even the ones that failed) was genuine and rational. It wasn't crazy that Amazon (Nasdaq: AMZN  ) was selling books over the Internet, or that Yahoo! (Nasdaq: YHOO  ) was selling banner adds. It was the valuations investors placed on that commerce that was certifiably insane -- and eventually bled investors dry in the aftermath. When investors put crazy valuations on an otherwise good idea, you get a valuation bubble.

An income bubble is an entirely different beast. In an income bubble, valuations look normal. It's the commerce that's lost its mind. A good example is banks and homebuilders in the middle of last decade. I recall looking at Beazer Homes (NYSE: BZH  ) circa 2005 and thinking, "Hey, this company trades at like 10 times earnings and less than book value! That's cheap!" (Idiot). In hindsight, its income was the bubble.

Ditto for banks like Citigroup (NYSE: C  ) . For most of the middle of last decade, large commercial banks traded at 10-12 times earnings and had dividend yields of 4%-5%. That seemed like a good deal. And from a valuation sense, it was. But the way they made money -- hawking subprime junk to widows and orphans -- was the bubble. And it was huge. When companies are temporarily able to pull in money through really idiotic means, you get an income bubble. 

Income bubbles are much more dangerous than valuations bubbles, if only because they're veiled. Valuations bubbles are relatively easy to spot. But spotting income bubbles requires detailed knowledge of an industry's dynamics -- something even insiders manage to fumble. Many people saw the dot-com crash coming, but very few people saw the financial crisis coming, regardless of what they say.

How is this relevant to today's bond bubble? Because I think you can make a case that Treasuries are both a valuation bubble and an income bubble. It's a valuation bubble in the sense that anyone willing to lend money at 3.65% for 30 years to a government with a dysfunctional legislature and a trigger-happy Fed has a painful ignorance of history. And it's an income bubble in the sense that, with the dollar as the world's reserve currency, many foreign investors are essentially forced to buy these bonds whether they think they're a good deal or not.

Some might say the dollar's status as a reserve currency is what justifies low rates; it makes Treasuries extraordinarily safe. That's probably true for the time being. But it seems absurd to rely on this idea that the-world-must-forever-and-always-worship-dollars continuing indefinitely, as so many Treasury investors are. A quote on this issue that sticks in my head comes from a director-general of the China Banking Regulatory Commission, who said in 2009: "Except for US Treasuries, what can you hold? … For everyone, including China, it is the only option." That's what big trade imbalances will do to you. He continued: "We hate you guys. Once you start issuing $1 trillion-$2 trillion … we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do."

In fairness, that's slight hyperbole. China has moved up in the world thanks to America's appetite for the stuff it makes -- a condition that requires it to buy our Treasuries. I don't think the dollar is going to turn into toilet paper overnight. But I do think the current arrangement where the rest of the world lends by force while we spend with abandon is one that cannot last forever. At least to the degree it's at today. It gives us an unfair living-standards advantage that many other countries would love to have and will aspire to achieve. In my book, that qualifies as a first-rate income bubble.

How will this end? No one knows. I sure don't. I just know that you should invest in things where the odds of success are in your favor. And with Treasury bonds at these prices, they're firmly not.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares of any of the companies mentioned in this article. is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Read/Post Comments (19) | Recommend This Article (41)

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  • Report this Comment On September 28, 2010, at 4:40 PM, ryanalexanderson wrote:

    Hi Morgan - good premise. Just out of curiosity, how would you classify the much-touted "gold bubble"? Would that require a new category?

    (I don't personally think we're in a gold bubble, incidentally, but I suspect we could be eventually.)

  • Report this Comment On September 28, 2010, at 4:43 PM, cmfhousel wrote:

    Paranoia and conspiracy bubble.

  • Report this Comment On September 28, 2010, at 5:37 PM, take2bank wrote:

    I think we are in a gold bubble, and as with all bubbles it will pop.

  • Report this Comment On September 28, 2010, at 5:50 PM, goalie37 wrote:

    Someone else on CAPS made a good point recently that bubbles can also be divided into greed bubbles and fear bubbles. I believe we are seeing both - fear driving people into bonds, and greed driving people into gold.

  • Report this Comment On September 28, 2010, at 5:52 PM, neutrinoman wrote:

    Excellent article.

    My own way of the thinking of this is to reject the idea that "there can't be a bond bubble, because there's an upper limit to bond market valuations." Without inflation or deflation, bond value is limited to principal plus total interest income. Inflationary expectations leads to a decline in bond prices, because lenders are expecting to be paid back in dollars worth less and less.


    * And deflationary expectations lead to an inflation in bond price, because lenders are expecting to be paid back in dollars worth more and more. There's theoretically no upper limit to this inflation of bond valuations. The valuation is exponentially sensitive to deflation, inflation, and interest rates.*


    Once gold passed about $1240/oz., it moved from being rich into bubble territory. Silver is now reaching for the same zone. But these bubbles will continue for a while, perhaps for up to another 2 years -- just a guess.

  • Report this Comment On September 28, 2010, at 6:16 PM, ryanalexanderson wrote:

    > Once gold passed about $1240/oz., it moved from being rich into bubble territory.

    Well, that kind of hits my point...what's with the magic number US$1240? How did you come by that number? There's no P/E behind that. No income. There's no reason for gold to be any particular value.

    And I don't think that paranoia and conspiracy are behind all gold purchases...there's a perception of QE2 and statements/actions by central banks - Japan, Brazil, UK, and US - that money printing will continue. That's enough to send gold up. If that's conspiracy, so be it, I guess.

    But I didn't mean to hijack the comment thread of this article to talk about gold. Sorry! Again, good article.

  • Report this Comment On September 28, 2010, at 6:30 PM, xetn wrote:

    I don't believe there is a gold bubble because so few people actually own gold. It is estimated that less than 5% buy gold. I am sure that that percentage will go up rapidly in the near future. That is because of the actions of the Fed monetizing the US debt and the so called "QE2" that is poised to start at any time Bernanke and Co decide the economy needs another kick in the butt. And it will have the same effect that the previous attempts have had. Zilch!

    All that will be accomplished will be is price inflation at a never before rate. Then everyone will be trying to get their hands on gold (the mania phase). That will be the real gold bubble.

  • Report this Comment On September 28, 2010, at 11:17 PM, pianovic wrote:

    take2bank: I agree. That's why I'm totally out of gold as of today.

  • Report this Comment On September 29, 2010, at 7:12 AM, kipnoll wrote:

    So very pertinent. This the best "think piece" I've seen in months. Especially good, your "disfunctional legislature and trgger-happy Fed". Scary times. . . way more than just a wall of worry to climb.

  • Report this Comment On September 29, 2010, at 11:24 AM, jrj90620 wrote:

    I though houses were in a bubble years before the peak.One of my favorite stock market books states that bull and bear markets go farther than any sane person would expect.Lots of talk about a gold bubble is at least a few years too soon.Gold,even using govt phony inflation figures,isn't near the adjusted 1980 high and using honest inflation figures would get you over $3K.Also,the U.S. continues declining and that decline is accelerating.The U.S. Dollar is not backed by any real commodity and is therefore nothing more than the common stock of a bankrupt govt.Would you own any stock in any company having as bad a balance sheet and future liabilities as the U.S. govt?Not if you're sane.I believe anyone purchasing govt debt today is crazy.This bond bubble burst will be the 3rd to hit the U.S. after the bursting of the tech and housing bubbles.Three strikes and you're out.A collapsing Dollar should send bonds crashing and gold soaring.Watch it happen.

  • Report this Comment On September 29, 2010, at 11:27 AM, slpmn wrote:

    Good article. I agree the rates seem unsustainably low. If its crazy to lend the US government at 3.65% for 30 years, what does that say about the bank that just refied my mortgage at 3.875% for 15 years? That said, if this is a bubble we're looking at, its one that's been developing for at least 25 years. That's how long interest rates have been falling in this country.

  • Report this Comment On September 29, 2010, at 11:30 AM, ChuckWoolery wrote:

    Great article, Morgan. I am in SLW and PHYS now and my returns have been great. More so recently with SLW, my best performing commodity ETF. I am just curious about why so many peolpe believe we are in a gold bubble? China is buying the US Debt and we keep printing money, why the concern?

  • Report this Comment On September 29, 2010, at 11:53 AM, slpmn wrote:

    One thing missing from the treasury "bubble" is speculation. No one in the world is buying treasuries in the hopes of doubling their money. Bubbles pop when speculators bail out at the same time. WIthout that element can it still "pop"? Gold, by the way, is a bubble. So is farmland.

  • Report this Comment On September 29, 2010, at 1:31 PM, TMFDiogenes wrote:

    I'm not sure I understand why bonds are an income bubble -- is the thesis the currency will depreciate or there'll be inflation so the income is overstated in nominal terms?

  • Report this Comment On September 29, 2010, at 2:01 PM, clayman14 wrote:

    Real inflation is at 8.5%, the pretend inflation given by the government of around 1% is why it is an income bubble. If your getting 4% income when your expenses are going up by 8% your in SERIOUS trouble. It's time to take out a second job or take out more debt. Problem is U.S. can't take out a second job because taxes are to high. How much more can they borrow is the question and when do the start cutting money supply?

  • Report this Comment On September 29, 2010, at 2:11 PM, outoffocus wrote:

    Bonds are an income bubble because even though the bond pays 3.65 %, the true yield is close to zero, making the bond way overpriced. Add that to the fact that the US gov is practically bankrupt (complete disconnect from fundamentals) and you have yourselves a bonified bubble.

  • Report this Comment On September 29, 2010, at 4:49 PM, shaileshnita wrote:

    This is a great work and clears my confusion as to why good valuation (such as P/E, P/B, P/S) don't always work. If the revenue of a company itself is part of a market bubble then the life is very tough for average stock pickers like me. The author of this article has rightly pointed out that it requires detailed knowledge of how a particular market is operating to spot a market bubble. Very few have time for this. That is why Warren Buffet goes for the stocks that are no-brainer and simple.

  • Report this Comment On September 30, 2010, at 5:07 PM, Brent2223 wrote:

    I'd say bubbles are nothing more than glorified pump and dump scemes. If one does not believe that bubbles are being manufacturer by the big market makers one shouldn't be in the market. Individual investors these days don't bother to understand what they are buying, so it's very easy to lead the sheep to the slaughter, dangling the promise of a carrot (ie get rich quick by getting into the bubble before everyone else), making money off them every step of the way until POP. Buffet has had it right for years, if you don't understand it don't buy it.

  • Report this Comment On October 04, 2010, at 5:44 AM, ilovesumm wrote:

    I agree with Brent2223 ,

    You could also add bandwagon bubbles, everytime everyone gets on the bandwagon its a bubble....

    Or beyond the norm bubble , treasuries are selling below historic norms , so they will revert to the norm which will mean big losses.

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