Bubbles are on a lot of minds lately. Bonds. Housing. Stocks. Are any of these in a bubble? How do we decide? A bubble is usually defined as a situation in which the value of an asset exceeds its true worth. What does that mean? How are we to know that the true worth of something differs from its price? It sounds like something St. Thomas Aquinas would think up.
Here is a reconstructed phase space of what is generally agreed to be a popping bubble--the Case-Shiller index. It's not always clear when the popping takes place. Is it the moment it falls from a high to which it never returns (or at least not for a considerable time)? That's first quarter, 2006 in the above figure. Is it when it becomes clear that no area of stability is going to form in the upper registers of phase space? That would be about the second quarter of 2008 in the above figure. Or is it only when the system returns to the area of stability that characterized it? That hasn't happened yet, but it looks imminent.
For today's discussion, consider the S&P 500 and the price of gold.
Starting from a remarkably similar starting point, they have reached pretty similar levels. But although the S&P 500 may be slightly ahead over our 20+ year chart, it hasn't always been so. In fact it is painfully obvious in hindsight that switching from stocks to gold in early 2000 would have been especially sweet.
One approach I have been working on is based on the notion of stability. It looks good for the Case-Shiller index at top, but that index has been adjusted for inflation--the gold price and the S&P 500 are not. We may be able to assess stability by reconstructing state spaces from the original time series.
Apart from the run-up in price over the past 20 years, the main feature on this graph is that the plot does not stray far from the green dashed line, which is the only part of the graph where areas of stability can appear. Apart from the cluster at about $300, there aren't any areas of stability. I'm not alarmed by this, and don't expect the $300 area to come into play again. This is a reminder of the importance of adjusting for inflation.
Even though this graph is also not corrected for inflation, it does not behave as the gold chart does, but cycles twice around the yellow dashed circle. In terms of a deviation from the regions of stability, it did get about as stretched as did the housing market, both in January 1998 and November 1999. It's current position is not stable but it is not nearly as extreme as it has been in the past.
Some have suggested that gold price is a proxy for inflation. So let's look at the S&P 500 with respect to gold. The comparison will be as follows: the difference between the S&P and the gold price, divided by the gold price.
Here we see a tremendous peak in early 2000. The current level of the index, however, does not seem out of line with respect to gold. If the S&P 500 is in a bubble, then so is gold.
Both the stock market and the dollar price of gold are influenced by monetary creation. As long as money continues to be created, we should expect both to increase in price. There have been times in the past when the money blew up the stock market much more rapidly than gold, and if that were to happen again, there may be an arbitrage opportunity. Such does not appear to be the case today. I find it hard to imagine that we will see the extremes of early 2000 again.
In a time of monetary or credit creation, there are opportunities to preserve wealth through investments in productive enterprises as well as gold. Unfortunately, it is difficult to distinguish between enterprises that are truly productive and those which merely look productive as long as the credits keep flowing.
Here is a reconstructed phase space of what is generally agreed to be a popping bubble--the Case-Shiller index. It's not always clear when the popping takes place. Is it the moment it falls from a high to which it never returns (or at least not for a considerable time)? That's first quarter, 2006 in the above figure. Is it when it becomes clear that no area of stability is going to form in the upper registers of phase space? That would be about the second quarter of 2008 in the above figure. Or is it only when the system returns to the area of stability that characterized it? That hasn't happened yet, but it looks imminent.
For today's discussion, consider the S&P 500 and the price of gold.
Starting from a remarkably similar starting point, they have reached pretty similar levels. But although the S&P 500 may be slightly ahead over our 20+ year chart, it hasn't always been so. In fact it is painfully obvious in hindsight that switching from stocks to gold in early 2000 would have been especially sweet.
One approach I have been working on is based on the notion of stability. It looks good for the Case-Shiller index at top, but that index has been adjusted for inflation--the gold price and the S&P 500 are not. We may be able to assess stability by reconstructing state spaces from the original time series.
Apart from the run-up in price over the past 20 years, the main feature on this graph is that the plot does not stray far from the green dashed line, which is the only part of the graph where areas of stability can appear. Apart from the cluster at about $300, there aren't any areas of stability. I'm not alarmed by this, and don't expect the $300 area to come into play again. This is a reminder of the importance of adjusting for inflation.
Even though this graph is also not corrected for inflation, it does not behave as the gold chart does, but cycles twice around the yellow dashed circle. In terms of a deviation from the regions of stability, it did get about as stretched as did the housing market, both in January 1998 and November 1999. It's current position is not stable but it is not nearly as extreme as it has been in the past.
Some have suggested that gold price is a proxy for inflation. So let's look at the S&P 500 with respect to gold. The comparison will be as follows: the difference between the S&P and the gold price, divided by the gold price.
Here we see a tremendous peak in early 2000. The current level of the index, however, does not seem out of line with respect to gold. If the S&P 500 is in a bubble, then so is gold.
Both the stock market and the dollar price of gold are influenced by monetary creation. As long as money continues to be created, we should expect both to increase in price. There have been times in the past when the money blew up the stock market much more rapidly than gold, and if that were to happen again, there may be an arbitrage opportunity. Such does not appear to be the case today. I find it hard to imagine that we will see the extremes of early 2000 again.
In a time of monetary or credit creation, there are opportunities to preserve wealth through investments in productive enterprises as well as gold. Unfortunately, it is difficult to distinguish between enterprises that are truly productive and those which merely look productive as long as the credits keep flowing.
Gold reacts more so to interest rate changes in relation to CPI.
ReplyDeleteWhen real rates are negative or accelerating to negative, gold gains against CPI as Gibson's Law suggests. But here's the startler--when real rates are positive or accelerating to positive, gold underperforms CPI! This dispels the belief that gold is a stable SoV. When real rates are +, the currency is a better SoV b/c it has a YIELD, unlike gold.
ReplyDeleteAnd yet the greatest bull market in gold (prior to our present one) occurred against the backdrop of a huge rise in interest rates.
ReplyDeleteIf interest rates rise because government bonds are weak, isn't a rising gold price a vote of non-confidence in the government's strength?
But were real rates positive? That's what everybody misses. Nobody looks at CPI to see if real rates are neg/pos, accelerating to neg/pos, and everybody forgets to account for CPI in figuring the real price of gold.
ReplyDeleteBack in the 70's bull run yes rates were rising, but not as fast as CPI. Under those conditions the DNA sequence responsible for SoV function is activated in gold and silver.
Unfortunately, a lot depends on whose numbers you believe. I think it was more a case of confidence in the US dollar falling until the gold held by the US balanced their outstanding bonds. Then people noticed they could get 19% (short-term).
DeleteOnly saw this post now.
ReplyDeleteRe your S&P phase space chart:
That circle traced out is the bear market of 2000-2012, no? If so, then if the S&P 500 is in a new secular bull market it should continue moving up along the blue dotted line.
Affirmative. Although in an advancing market it will actually move out towards the right, before curving upwards, because of the 16 month lag in the ordinate.
Deletewhy choose to compare two bubbles? why not pick median income vs any of your choices above?
ReplyDeleteA lot of it was the relative ease of acquiring the two data sets.
Deleteyou are comparing bubble with bubble though?
ReplyDeleteYes. I leave it to you to decide what you want to have after the popping. Stock in productive companies will always be worth something. Admittedly, at times like this, it can be difficult to tell which are really productive and which merely look productive due to the flood of credit.
Delete