Please ensure Javascript is enabled for purposes of website accessibility

A Tale of Two Bubbles

By Morgan Housel – Updated Apr 6, 2017 at 10:22AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

And why you should beware bonds.

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. Amazon.com 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.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Citigroup Inc. Stock Quote
Citigroup Inc.
C
$44.26 (-2.90%) $-1.32
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$113.78 (-3.01%) $-3.53
Beazer Homes USA, Inc. Stock Quote
Beazer Homes USA, Inc.
BZH
$10.97 (-1.26%) $0.14

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
329%
 
S&P 500 Returns
106%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/24/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.