Wednesday, June 9, 2010

The Good, The Bad, And The Bubble

How does an investor decide if debt is good or bad? 12 months ago the government debt in the country of Greece was considered one of the safest investments in the world. It held a debt rating of AAA. It was perceived by the investment community as not only good, but great debt. A few weeks ago the country was on the verge of bankruptcy with the debt trading at a fraction of its former value. Its debt became bad debt that was only saved with a bail out.

During the spring of 2007 a form of debt called subprime became the darling of the investment world. It held a debt rating of AAA. 12 months later during 2008, subprime debt could not even find a price in the open market because its value was plunging so rapidly. Many investors holding what they perceived as good debt ended up getting wiped out. Once again these investors holding bad debt were only saved by a bail out.

Today the United States government debt, the Treasury bond market, is the darling of the investment world. The treasury debt of our country holds a rating of AAA. Investors around the world have become spooked by the Euro debt crisis and have rushed into American treasuries, pushing the prices to historically record levels. (Low interest rates)

Many investors believe that the “good” United States debt today will soon turn “bad.” Some have even called it a bubble. Is it possible the United States good debt could turn bad? Looking at bubbles throughout history, investors have learned that they arrive with two main characteristics:

1. There is a record new supply coming onto the market at the same time investors are willing to pay record high prices.

For example: At the end of 1998 the NASDAQ crossed 1500. Over the next 18 months there was an onslaught of new technology IPO’s that poured in to the market. A record amount of new stock was issued at a time when stock prices were rocketing higher every month, until they peaked. Then the new supply became unsustainable, and prices collapsed.

The same situation occurred in the summer of 2005 as builders flooded the market with an endless supply of new homes. The more homes they built, the higher the prices rose. Then the new supply became unsustainable, and prices collapsed.

Last week our United States treasury debt crossed $13 trillion. Our debt to GDP level has now reached 90%. New debt supply continues to grow every month as tax receipts fall and spending continues to rise. In 2009 we added $1.9 trillion to the deficit, which is close to four times the record annual supply seen in 2007. This new massive amount of supply comes at a time when investors are willing to pay the highest prices in history to purchase the debt, similar to technology stock investors in 2000 and real estate investors in 2005.

At some point the new supply will become unsustainable……

2. The public is rushing into the market.

Similar to the NASDAQ bubble in 2000 and the real estate bubble in 2005, the bond market has seen the public, the every day investor, rush in with full steam. When investors left the stock market in 2000, they bought into real estate which they perceived as the ultimate form of safety.

In 2010, the average investor has left what they perceive as risk in stocks and real estate, and they have again rushed into what they perceive as safe. Bonds in their mind are as good as cash. What most of the public does not know is that bonds lose value just as stocks do. In the 1970’s bond investors were pummeled for a full decade as interest rates rose.

Today the average investor is buying bonds at record high prices, the second major sign of a bubble forming.

So what is the key determinant of what makes debt good or bad? It is a word found continuously throughout this discussion: perception. Fundamentally bad debt can be traded at a price in the open market that is far above its true value, only because investors mistakenly perceive its value at a higher price.

However, when that perception changes it usually comes in the form of a rapid collapse as seen recently in the country of Greece.

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