So, how plausible are these scenarios? "1) Great Depression rerun - trade wars, banking collapse continues, restrictive regulation and legislation crushing enterprise, large government borrowings crowding out productive private sector investment, and so on. What will that do to inflation? It won't be a matter of what the inflation rate will be, it will be a matter of how much *deflation* we have. Inflation could easily be -1% or -2% for the next 10 years under this scenario." Paul Volcker said the recent collapse was even quicker on a global basis than the Great Depression. In other words, one of the most respected and credible financiers in the world sees at least one sign that *it could be worse* than the 1930s. George Soros has made similar comments, and at least compared the current situation to the 1930s in some respects. A governor of the Bank of England said the UK may be in for a similar decade as Japan in the 1990s. These are not my opinions. They are the observations of influential and respected members of the financial and government elite, people with excellent track records. If they are making comparisons to the 1930s and Japan in the 1990s, then I think no reasonable person could say it is totally implausible that we might have a re-run or at least something close to it. "2) Long-term stagnation - think Japan 1990s. Less extreme than the first scenario, this would see very low growth over the decade, and inflation could be perhaps in a -1% to +1% range." Well, this is a lower hurdle than the Depression II scenario. Even more plausible. "3) Eventual recovery with anaemic growth - here would could postulate a low growth economic with restrictive credit and conservative bank lending, resulting in fairly low inflation in the 0-2% range." Can anyone really say with honesty that this scenario is implausible? The banking sector is bogged down and won't be lending much anytime soon, and even in 4-5 years they are going to be much more conservative than in the 2000s - either by choice, or because of more regulation, restriction, and oversight. We had lowish inflation in the 2000s during a boom - so 0-2% average inflation in the aftermath of a historic bust seems pretty reasonable. Let us look at historic examples and see what happened. In the 1930s, US treasury yields went lower all decade and eventually hit a trough of 1.5% in 1941-42 (can't remember the exact date). US Treasuries were the best performing asset during the Depression and if you had invested in 10 year bonds, you would not only have got all your income, you would have made a capital gain too, AND the real price level fell so you made an extra inflation-adjusted gain there too - a triple whammy of profit. Thus if we see a re-run of the 1930s, Treasuries at 3% yields are far from a bubble, not even overvalued, nor even fair valued - rather, they would be *massively undervalued*, and the buy of the decade. Take the less extreme scenario, a rerun of Japan in the 1990s. In Japan 10 year JGB yields fell from 6-7% (IIRC) and kept falling for 12-14 years, eventually hitting a low of 0.5% in the early 2000s. Once again, you would have made your income (almost risk-free), a huge capital gain, and the price level was fairly stagnant so inflation was not a worry either. JGBs in the early 90s were the best investment asset class in Japan for the next decade. Note the commonalities - both the 1920s and 1980s Japan had huge stock market and real estate booms, along with easy credit. They than had huge busts as the banking system was frozen up for years under the massive burden of huge real estate debts and commercial loans going soar. Industry was hammered due to the freezing up of credit. Commodity prices tumbled and GDP collapsed rapidly. Sound familiar? Thus, we have 3 scenarios here, each of which have reasonable plausibility. Even if you don't think they will play out, I don't see how any impartial rational observer can say they are totally implausible. Therefore, Treasuries cannot be a bubble. What's more, under 2 of the scenarios, which have parallels from past real-estate bubble aftermaths, Treasuries would actually be *undervalued* and a good buying opportunity. I therefore contend that Warren Buffett is totally wrong to describe US Treasuries as a bubble. And to compare it with the absurd excess of the dot.com and real estate boombs, where NO plausible assessment of fundamentals and valuations could come up with a fair value anywhere near peak bubble prices, is an indefensible position. Either Buffett has no clue about how to value US Treasuries (unlikely), or he has no clue what a bubble is (unlikely), or he just hasn't though this through. The worst you can say about Treasuries is that they are too expensive. But that requires you to forecast a decent level of inflation for the next decade, after a historic bust. In my view that is not the way to bet, but at least it's not an implausible scenario. Describing Treasuries as a bubble requires a belief in 5%+ inflation each year for the next 10 years - when we have a post-bubble bust, economic circumstances that usually result in *deflation*. I see no grounds for holding this belief. Some people cite rising government debt levels in their fears of re-emerging inflation. But look at Japan in the 1990s. Their debt went to over 100% of GDP, yet inflation was non existent. Inflation is not caused by government debt issuance alone. It is caused by credit creation, which needs a healthy expanding banking system, or debasement by a central bank which literally prints money a la Weimar Germany or Zimbabwe. The latter is not going to happen, and the former seems a stretch. But it doesn't even matter - *you don't have to be a bond bull to dismiss the "bubble" appelation*. All you have to do is see one or two possible scenarios where inflation would be around 1% or lower for the next 10 years on average. That's it.
I somewhat agree, however this is not germane to the thread. This thread is NOT about whether anyone is bullish or bearish on bonds. This thread is about Warren Buffett either being clueless about bond valuation, totally ignorant of the definition of a bubble, or guilty of extreme intellectual sloppiness - along with the legions of sheep who will swallow his argument without examining it on its merits (which is ironic, since Buffett would strongly disapprove of such sheep-like following and always tell people to think for themselves). Given that I am 99% sure he knows how to value bonds, and what a bubble is, I can only assume it's the latter reason. Now, I do happen to be somewhat bullish on bonds, more the 10 year than 30 year, and more other countries than the US (e.g. UK gilts). I use Japan 1990s and US 1930s as my reference for what could well happen. The near-universal agreement with Buffett's pronouncement, and the fact that at 3% bond yields *feel* expensive, because they are nominally much lower than recent history, all create more and more upside to a contrarian position *if we are right*. If we are right and we get stagnation, deflation etc, then a 1-2% deflation rate means that Treasuries currently yield 4-5% in *real terms*. Compare this to the current 2% real yield on TIPS today. This means potentially huge capital gains on bonds. But all this is a trading thesis I (and some others) have, it doesn't mean we are right, and it is totally irrelevant to whether Treasuries are a bubble. The ONLY thing that matters on whether Treasuries are a bubble is if there is *no plausible scenario* where inflation could average 1% or less for the next 10 years. Otherwise, they cannot be a bubble. Buffett, Marc Faber, Jim Rogers etc are totally wrong on this point, and elementary logic and high-school bond valuation arithmetic proves it. That is all.
hard for models to be in a spectacular bubble like amazon or yahoo, since their value can't really go up 5x (I guess they could, if we end up paying $500 for a $100 bond). Giving the govt money for a long time at 3% interest is plain stupid, especially given that they're printing money as fast as they can feed paper into the presses or push enter on their keyboards. The problem for many (myself included) is trying to find something less stupid to do with their money that they feel confident about.
Cutten: Having lived through the 70's and 80's and remembering 21% prime and 19% yields on gov't bonds, I look forward to your next post about inflationary expectations. Thanks for the interesting post. Stosh
Cutten: great work... I wonder why I've been wasting my time in the other thread (have you been reading?) But yes... lets talk about inflationary expectations a la Volcker in 1980s. It seems there is a disconnect between deflationary expectations (seen in treasuries) and inflationary expectations (seen in gold/silver). All I can gauge is that this comes from deflationary expections in the credit driven part of our monetary system happening at the same time common understanding expects currency circulation ( / money base) will be increasing worldwide to attempt to offset this. Gold and silver are targets of least resistance, considering how small and uneconomically-bound (unlike oil) those markets are. I think there is a massive disconnect in the public's understanding of what makes money supply, particularly the credit multiplier part. That is driving the conflicting signals. (ie even up as high as the Fed.. if they were able to properly measure the real credit system multiplier on base money, they would've already solved the problem with an injection of money equal to that lost. I don't think anyone knows how to measure it objectively.. I think they are waiting and seeing how prices of real estate assets responds to send the signal when they have it right.. Once that market clears the dump, watch out.. ).
You're too fixated on the concept of "bubble." Were Detroit real estate prices in bubble mode? Not by any yardstick. But they were still a horrendous buy. GM wasn't a bubble either. The stock hasn't traded a double digit p/e in years yet if you're long GM because it was "cheap" you're toast. Yes I agree that in the micro economic climate Treasury yields are not necessarily "too low". But the long end of the curve is priced on factors other than stringing together 30years of anticipated Fed Funds rates. The market realizes more and more that there's a SHITLOAD of risk in holding long dated Treasury paper. Default risk? Not in the traditional sense because governments can print. What good though is guaranteed principal if you know little about the future notional value of your principal. The same Deadbeat Nation that bk's credit card balances and leaves the keys in the mailbox is not the best bet to hunker down pioneer style and raise taxes through the roof while cutting spending to the bone. Especially with the immense non-discretionary obligations of the budget. In 30 years I'd reckon half of Congress will look like Maxine Waters and Luis Gutierrez. If you think those folks are worth betting on-hell at these Treasury prices you're laying odds on them -well I think that's a crazy risk. The macro play will be shorting Treasuries against longs in countries with a more productive and stable demographic-particularly emerging economies with fewer mandated social obligations already in place.
A bubble by any other name... I know what you're saying but isn't terminology, as a sticking point, rather mute at this juncture. Fed forced rates/flight to safety Ok, bonds are crowded due to limited choices for the extremely wealthy. T bills at 0%. When equities rise and bonds liquidate what will we name it? If/when USD drops and gold is thwarted what then? When TLT deflates to 91.73 in a year or so what will we call hyper inflation?
Cutten great post and very interesting thoughts. I have been thinking about this for the last few weeks but have not created such a well laid out thought process as you just have. "Something is only a bubble if the price is *so high*, that even an optimistic reading of the fundamentals cannot justify a valuation anywhere near that." When we think of what Buffet was postulating with his bond bubble comments we should look at what expectations he has to create such a view. And Like what you have shown his expectations must be historically high levels of inflation due to the large levels of monetary stimulus. I think we will get clues if this is correct over the next 2 quarters. But the one thing that must happen for this to occur is for lending to resume and in a big way. I am not sure if that is something that will happen with the current state of our financial system and the regulatory burdens that will be placed on it. The resumption of lending is also only one part of the puzzle the other part will be the stabilization and growth in GDP which has yet to happen but can only happen with the prior occurring. I think one major problem that a majority of analyst have in this current situation is a comparison problem. Many people are looking to the depression era or the Japan situation and not looking at this as it is something that is in many ways very different from both. Sure we can use them as a gauge but you need to adapt those views to include the differences in scale, interconnectivity, and structure of the world economy.
No one has yet said why it's a bubble. All the arguments against have just said it's poor value. Let's take each in turn. It does matter if it's a bubble. Why? Because bubbles eventually burst, *even if the good fundamentals stay intact*. High price alone is enough, when sustained for years, to cause a huge bust. Technology has continued to boom in the 2000s, the promise of the internet was arguably *underestimated*, yet here the nasdaq languishes 75% off its highs from 2000. Therefore if its a bubble, you should exit and not invest, even if you think we have 10 years of depression. Whereas if you are a bear because you expect future inflation, or massive issuance, a la Pabst, then you can only be bearish *if those fundies stay intact*. In other words, if this slump turns into a depression, and there is huge demand even in the face of rising supply and debt/GDP ratios, then you have a direct challenge to your thesis in the form of fundamentals getting more bullish for the bond market. You can be flexible, because your position is dependent on a view of the future. With a bubble, it is a sell (at least in value investment terms) *under all possible future scenarios*. That's why it's an important distinction. Secondly, a lot of people have been saying off-hand that the market is expensive. Historically the yields are low, no doubt. But a low yield does not necessarily imply expensive, as I pointed out previously. Under deflation, or even 0% inflation, 3% yields are reasonable for a low-risk safe haven asset. Once you throw in an unstable banking system and insolvent FDIC, 3% could actually be *cheap*. All the arguments for inflation, supply, government spending, currency debasement etc were also present in the 1930s and 1990s Japan, times of long-term collapsing yields and soaring bond mega-bulls. FDR took the dollar off the gold-standard, massively expanded the federal government, spent and borrowed significantly, issued lots of new supply - inflation was non-existent and bonds kept going higher. Japan in the the 90s and early 2000s saw a lot of the same things - huge supply increases, huge spending increases etc. Yet inflation was non-existent and yields went lower and lower to 0.5% on the 10 year. Here we are facing a similar banking and real-estate crisis. Volcker, Soros and others have made the comparisons. Since the inflation drivers did *not* cause inflation in the 30s and 90s, why would they this time? Since credit collapse and a historic real estate and stock market bust caused zero inflation or deflation in the 30s and 90s, why wouldn't it do the same this time? And if it does, why wouldn't bonds rally just like they did those other two times? That's the question every bond bear - let alone the "bubble" crowd - have to answer. So far I have not yet heard a convincing argument.
Just remember that while you lived through 19% yields, someone born around WWI lived through 1.5% yields in the early 40s. Trying to figure out why yields were so high circa 1980, and so low circa 1941-42, is more likely to give insight than just referring to the era that you - by pure chance - happened to have lived through personally. It's important to identify if there's any personal bias influencing the trading view - ultimately the only way to form an objective opinion is to look at as much economic and financial history as possible, to develop true perspective rather than "fighting the last war".