The Next Bubble Has Started To Pop

The nasty problem with most investment bubbles is that they tend to keep inflating long after prudent people point out their existence. Over time, the rational folks who warn of trouble ahead lose their credibility and investors decide that we live in a new world where the old rules just don't apply. So when the "pop" finally comes, lots of people lose lots of money.

That was the case with the Tech Bubble of the late '90s. Alan Greenspan warned of irrational exuberance in the stock market in 1997 but when the dot-com stocks just kept rising, people assumed that Greenspan and Warren Buffett were just old fogies that didn't understand the internet age. Three years later, the bubble popped and billions in wealth vaporized.

The same was true of the real estate bubble that has devastated developers and speculators in the Sun Belt during the last year or two. For years, home prices just kept rising and rising long after a number of economists warned that trees never grow to the sky. Those old fogies didn't understand that with thousands of Baby Boomers retiring every day, it was impossible to have too much real estate in Las Vegas, Miami, Phoenix, San Diego or the other warm places that all the retirees wanted to move.

Since most of the speculation was financed with borrowed money, that bubble popped quickly and violently and has played a major role in creating the financial crisis we are facing today.

The next bubble--in U.S. Treasury notes and bonds--will be the most shocking in recent memory--not due to leverage but because investors have flooded into bond funds specifically because they are supposed to be the most conservative, low-risk investments in the world.

This flight to the illusion of safety has created so much demand for U.S. Treasury debt that, despite its precarious financial condition, our government has been able to borrow money at very low rates of interest.

All the conversation and reports from Washington for the last month have focused on the financial crisis and the stimulus plan that is being enacted to jump-start the economy. (By the way, am I the only one who thinks that a "stimulus package" sounds like something offered in the back room of a gentleman's club?--But I digress).

While the pols and pundits have been silent, the financial markets are flashing huge warning signs. The price of gold has gone up by 30 percent and the U.S. government's long term cost of borrowing has gone up by almost 50 percent during the last month. The markets are coming to the conclusion that in the absence of tax increases (which are not even being considered by Republicans or Democrats), our government will pay for its multi-trillion dollar deficits, bailouts, and stimulus plans by simply printing more money.

That money will be borrowed from countries and fund managers who are already demanding a higher rate of interest to cover the inflation risk they are taking by loaning trillions to an insolvent country.

As rates go up, bond prices go down. Most U.S. Treasury bond funds were down about 5 percent for the year before last Friday when the popping noise increased in volume. There was an auction of 30 year treasuries on Thursday where bonds were price to yield 3.54 percent. By Friday afternoon, those bonds had lost 4 percent of their value in one day and are now priced to yield 3.70 percent.

Think about that. Investors lost 4 percent of their money in one day by buying "safe" U.S. government bonds. Over the long holiday weekend, the news channels were full of conversation and discussion about the final version of the Stimulus Plan. Did you hear any conversation or reporting at all about the massive drop in bond and bond fund prices from any politicians or reporters? Have any of them even discussed the meaning of gold's increase from $700 to $950 an ounce in just the last few weeks?

Of course not. That's because the politicians and news media have all decided that they will only discuss whether the stimulus package will work--not how we're going to pay for it. The financial markets--and the countries and funds that are financing our spending--didn't get the message. They are becoming obsessed with how we're going to pay for this and what multi-trillion dollar deficits will do the buying power of the dollar in years to come. Our creditors will continue to demand--and get--higher interest rates from us going forward. As treasury bond yields go up, bond and bond fund prices will plummet.

Earlier this month I wrote (It's Time To Own Stocks and Stuff - Feb. 5) that it is time to invest in hard assets and solid companies with strong balance sheets and pricing power. Investors should set aside the cash they'll need over the next couple years plus whatever else they are willing to invest for zero return to enable them to sleep at night. The rest of it should go into good stuff--not bonds.

Investment in long term bond funds at this point is neither conservative nor safe. U.S. Treasuries were the one asset class that didn't lose value last year. That's because there was limited supply and seemingly unlimited demand as panicked investors tried to move out of harm's way.

Based on the popping noise coming from the markets, this year may be very different.