Investment bubbles have been a fact of life for centuries, and the 21st century is no different. There are potential bubbles forming in several areas, and exchange traded fund (ETF) investors need to be on the alert and ready with a coping strategy.
Gold, oil, stocks and government bonds have experienced large run-ups that have put prices above their historic averages and some feel that these levels aren’t being justified by fundamentals, comments Shawn Tully for Fortune. [How to spot and avoid bubbles.]
Observers have pointed to that low interest rates that have inundated banks with funds that are basically there to be loaned out cheaply to bid up assets. However, there are some like Allan Meltzer, the distinguished monetarist at Carnegie Mellon, who argue that we are in a credit crunch and banks aren’t lending out all that extra cash.
Tully cautions investors to note of the possibility of overpriced valuations in the four different assets.
Treasuries. The 10-year Treasury is now 3.6%, below the 5.5% average rate between 1993 and 2007 when inflation was at around 3%. If inflation is 3% now, that would put the real rate after inflation of the Treasury note at 0.6%. As the economy recovers, the threat of inflation will also cause the Fed to increase rates – when yields rise, bond prices fall. [Good times in bond ETFs coming to an end?]
- iShares Lehman 7-10 Yr Treasury Bond Fund (NYSEArca: IEF)
Oil. Oil may be hovering between $70 to $80 a barrel, which has oil companies making a nice profit with the cost of production at around $55 to $60 a barrel. It is logical that oil companies would want to make more money, so they drill more oil until the high demand meets the low supply, which would ultimately bring oil prices down. [Oil prices step back.]
- United States Oil (NYSEArca: USO)
Gold. Inflationary fear and a declining dollar has a lot of investors flocking to gold. Now that gold has been pushed up beyond the $1,000 level, a lot of ordinary people are selling jewelry and other gold items to capitalize on the high prices. The last time a similar situation occurred, it was silver in the 1980s; silver prices dropped from $50 to $15 less than a year. [Why gold may still have some life.]
- SPDR Gold Shares (NYSEArca: GLD)
Stocks: S&P 500. Using a formula developed by economist Robert Shiller, the S&P’s P/E multiple stands at a high 20 and dividend yield is just above 2%. If investors want a 10% return on stocks, then earnings need to increase 8%, with a 3% inflation and 5% annually in real terms. However, earnings usually reflect GDP, which grows around 3% over the long run – a 3% real GDP growth isn’t enough to lift profits 5%. The only solution is a fallback to historic P/Es of about 14, which would require a 29% correction. [Spotlight: SPY]
- SPDRs S&P 500 (NYSEArca: SPY)
You don’t have to sit out bubbles if you have a sell strategy and you stick to it. We use a very simple trend following strategy. It is easy to get caught inside of a bubble and then miss warning signs that are telling you to get out. This is why we have an 8% stop loss – once a fund declines 8% off the recent high or dips below its 200-day moving average, we get out. This protects us from further losses and eliminates emotional decision making. More on trend following can be found in The ETF Trend Following Playbook.
For more information on trend following, visit our trend following category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.