Investing 101: Bull Market or Bubble? Know the Difference
Source: Paul Mladjenovic, Prosperity Alert (5/4/10)
To build wealth it is important to discern where NOT to put your money.
For investors, a "bubble" translates into a temporary head fake of financial success followed by a painful bearish plunge. We have all seen them. The most obvious recent examples include the Internet and tech stock bubbles that popped in 2000–2001 and the housing bubble that popped big time in 2007–2008.
If investors had seen these bubble conditions coming, they of course would have reduced their exposure to that asset class and headed for the safety of the sidelines. But when a bubble is in its "pre-pop" stage it has all the looks and emotions of a torrid bull market that many are fooled into thinking will go on indefinitely.
For the record, I never bought Internet stocks during the late 1990s because I thought they were speculations and not true investments. And, I started warning about that inflating bubble in 1998.
As the Internet and tech stock bubble continued to inflate during 1999, I started to question my wisdom (sanity?), as those stocks kept rising while I looked dumb for avoiding them. Sometimes, bubbles can last a lot longer than we anticipate.
The same thing happened with the housing bubble that was inflating during 2002–2006. I told my readers and students that the housing bubble would definitely pop and be a very painful event. I made that forecast public in my national seminars and then on the Internet during 2003–2004.
In 2005, the housing bubble continued to inflate and. . .again. . .I felt (looked?) dumb. But I thought about a prudent rule when it comes to avoiding the wretched aftermath of an asset bubble that pops. . .
It Is Better to Get Out a Year too Early Than a Day too Late
During those years (and still today), I always enjoyed the opportunity to ask someone in the financial industry (especially investment portfolio managers) the following question:
What Is the Difference Between a Bull Market and a Bubble?
They should know. . .right?
I have also asked this question of students in my financial seminars. On average, the students gave more reasonable answers than most of the "financial experts." For those of you that would like to know, here is the essential difference:
A Bull Market Is a "Natural Event" Driven by Free Markets.
A Bubble Is an "Unnatural" Event Driven by Government.
A bull market means that the price rise of a particular asset or asset class is driven by the natural, free market dynamics of buyers and sellers. As we know from "Economics 101" (or hope we know), when there are more buyers than sellers of a given asset (or product or service), all things being equal, the price of that given asset will rise. If there are more sellers, then of course the price of it will fall. In other words, "bull markets" are natural and healthy events that can easily last months, years or decades.
How About a "Bubble?"
A bubble occurs when a normal bull market gains artificial stimulus typically from expansive credit and/or money supply infusions. This artificial stimulus usually comes from increased "injections" of new credit; new money creation which originates from governmental sources (such as a nation's central bank or perhaps from other central banks). The artificial stimulus can also come when the central bank lowers (again, artificially) interest rates to levels below realistic market levels. It may also come from the government's treasury.
The housing bubble had all the hallmarks of a bubble years before the public (and "experts") finally noticed. The housing industry received massive injections of credit coupled with artificially low interest rates and artificially lax lending standards starting in 2001. These policies were aggressively applied by the Federal Reserve (America's central bank), the U.S. Treasury and by governmental entities (such as "Fannie Mae" and "Freddie Mac"). Of course, when plenty of "easy money" is chasing a finite supply of a particular asset (such as real estate), you will overstimulate demand and cause prices to skyrocket. And thus, a bubble is eventually created.
Bubbles may "feel good" for the early participants due to incredible price increases. However, as the great economist Ludwig von Mises observed long ago, bubbles may create an artificial "boom" but this euphoric event is followed by an equally jolting and painful decline. . .the "bust."
For investors, it pays to be very wary of what looks like a "fantastic bull market." Ask yourself if artificial stimulants are present (excessive credit, money supply increases, etc.).
A good example of an asset class that is currently in a bubble is U.S. Treasury bonds. Trillions of dollars (created) from the Federal Reserve and governments such as China have been pumped into these securities. These bonds have a very low, fixed interest rate and are very susceptible to dropping in value in the event of rising inflation and interest rates. More on this in future essays.
Are there any assets in today's economy that are in a true bull market? Yes there are. A good example of a true bull market is precious metals such as gold and silver. Gold and silver have increased in value by over 300% since 2000.
Recently, a market pundit remarked that gold was a bubble, but this is not accurate. Why?
First of all, gold is not a bubble because there is no excessive credit or other artificial stimulant being pumped into the gold market. In fact, many central banks have even sold much of their gold holdings during the past decade. The bottom line is that there is no evidence that gold's price has been driven higher due to government intervention.
But Is Gold in a Bull Market?
Gold is in a bull market given its performance and given the supply and demand fundamentals. According to industry sources, the worldwide supply of gold is tightening. Meanwhile, demand for gold is steadily rising as more and more investors and institutions see gold (and silver) as a proven store of value and hedge against inflation. In addition, gold is unique in that it does not have "counterparty" risk that is present in most paper assets (such as stocks, bonds, mortgage securities and mutual funds). Lastly, gold has had nine straight "up" years which certainly confirms its ability to retain and grow in value.
For more details about bull markets and bubbles and other events that affect your wealth-building pursuits, get the Prosperity Alert newsletter.
The bottom line is that investors need to keep vigilant about assets and keep asking questions about all the possible reasons why a particular asset's price is rising (or falling). If you determine that artificial forces (beyond the scope of supply and demand fundamentals) are the main culprit to an asset's price rise, then you can take steps to avoid the inevitable collapse that will eventually follow.
Paul Mladjenovic, CFP, is a national seminar leader, educator and author of Stock Investing for Dummies and other books. He is the editor of the Prosperity Alert newsletter. His blog is at http://www.Mladjenovic.blogspot.com.