Krugman on the "Bond Bubble"

[NYD3030]

http://www.nytimes.com/2013/05/10/opinion/krugman-bernanke-blower-of-bubbles.html?partner=rssnyt&emc=rss&_r=0

Paul Krugman's take on whether or not we're experiencing a stock or bond bubble.  The short answer is no and no.

I've seen some posters here and a ton over at Bogleheads claiming otherwise, and some proclaiming that they are withholding investment in bonds or they've totally divested.  The perception of interest rate risk is pretty omnipresent, but of course market timing is a big no-no and nobody knows when/if the fed is going to raise rates.  So are all y'all getting out of bonds due to the "bubble" or forging ahead with your AA, all of this chatter be damned?

[Joet]

seems like most people here are 100% equities , because [paraphrasing] "... everybody knows that equities outperform in the long run all other asset classes...", as if backtesting means anything :)

[destron]

of course market timing is a big no-no and nobody knows when/if the fed is going to raise rates.

This is the key thing here for me.

I am in the accumulation phase of my 'stache and I hold about 15% bonds. I admit this is a rather low percentage for bogleheads (especially since I mostly follow one of their investment plans).

[yolfer]

"As it turns out, however, dislike for bearded Princeton professors is not a good basis for investment strategy."

LOL

[grantmeaname]

seems like most people here are 100% equities , because [paraphrasing] "... everybody knows that equities outperform in the long run all other asset classes...", as if backtesting means anything :)

I think very, very few people here who aren't twenty years old are 100% equities. Equities do outperform all other major asset classes in the long run, and backtesting does mean something. /thread.

If not bonds, then where would you put the fixed portion of your portfolio? You can't just temporarily swallow your risk aversion, after all. I work for a financial advisor, and it's an interesting conversation we're having (as are all the talking heads around the 'tubes, naturally). One option is to decrease your average duration in the fixed portion of your portfolio; another is to decrease your bond allocation but dial down the risk of both the fixed and equity buckets, with shorter duration bonds, more cash uninvested, or dividend-paying blue chips. Those all seem like reasonable ideas, but it's all market timing to me. I say make sure you've got your heading right, then full steam ahead.

[Joet]

Just thought this was a cool sample of our recent history. Guess what each of these notes has in common?
Backtesting your portfolio and basing future returns on it is about as effective as driving your car backwards.

[grantmeaname]

Using sarcasm instead of meaningfully engaging my points is super helpful and really challenges us both and the other 70 readers of this thread to think critically about things, doesn't it?

[Joet]

I did, perhaps you missed it. Each one of those countries listed had a nice backtested theory on investing. I can prove with equal certainty the existence of the Great Spaghetti Monster as you can regarding equities outperforming all asset classes into the future.

We make our choices, and hope for the best. It certainly seems like equities do well in the long run.

[SwordGuy]

I wouldn't invest in any city or state bond where they couldn't demonstrate a long term and current, independently audited positive cash flow and fully funded pension fund.  Otherwise bankuptcy is a looming threat as the baby boomers retire.

[Bank]

Maybe I'm missing something -- what do photos of currencies have to do with equity risk premiums (foreign or domestic) over time?  Feel free to use big words -- I work in finance, although not in the selling or buying of investment securities.  But I'm going to need more than what you've posted so far to either agree or disagree with your points here.

[Joet]

I don't know anything, we make our own choices at the end of the day don't we? It was just a [tongue in cheek] counterpoint to * 'everyone knowing equities are the best asset class into the future'


*unless you were a citizen of Russia, Germany, China, Argentina, Brazil, eastern block nations, etc


**everyone also knows the US is special and our currency could never collapse

Does this information mean that there is a known, superior alternative to equities? Of course not. My crystal ball is cloudy. But so is everybody elses.

[KingCoin]

It's not necessary to believe that bonds are in a bubble to have a bond allocation of 10% or less. You can believe that rates will stay low, and indeed may even go lower, but still find them an unattractive asset to hold in your portfolio. With the 10yr bond at 1.8%, you're almost guaranteed to underperform inflation (if you buy TIPS, you are guaranteed to underperform inflation to maturity). If rates drop drop to 1%, you'll get a one time pop of about 6.5%. Not much to write home about given a near ideal turn of events for the asset class.

Believing that equities will have a higher return has little to do with "backtesting", and much more to do with how equities are valued. The price of most equities implies a double digit discount factor to future earnings. This is to say, if companies earn what they think they're going to earn, they will yield a double-digit return to investors. The discount factor includes a risk premium due to equity volatility and uncertainty about earnings (the opposite is true of government bonds). Could companies earn way less than they think they will over the long haul so-as to underperform even treasuries? Anything's possible. I don't think anywhere here claims to know exactly how assets are going to perform into the future, but that doesn't mean history and the fundamentals of how assets are valued is anywhere near worthless.

[matchewed]

So because of nothing we shouldn't be making the statement that equities are the best performing asset class out there. Gotcha. Duly noted to not make any prediction about the future. I'll just fling my money around randomly since everything is unpredictable.

Look I'm not saying I know the future any more than you do. But seriously I don't know what your comments mean in context of the article. If you think Krugman is full of it maybe just say why, discuss some points. Going around and telling people they can't predict the future whenever they make an educated guess is just kinda silly.

[grantmeaname]

I don't know anything, we make our own choices at the end of the day don't we? It was just a [tongue in cheek] counterpoint to * 'everyone knowing equities are the best asset class into the future'

*unless you were a citizen of Russia, Germany, China, Argentina, Brazil, eastern block nations, etc

It's "eastern bloc". The fact that the markets collapsed was a bad thing for equities as well as every other asset class. We're talking about the comparative performance of different classes, so the fact that collapses happen has nothing to do with the discussion unless we're talking about some asset class that magically survives market collapses. For those of us without a vault and larger private army than the greatest mob of a market crash, I'm not sure there is one.

**everyone also knows the US is special and our currency could never collapse

Half of your examples are forex crises, which the US is immune to for the near future since we're the currency of international reserve and it would take an enormous shift for that to change. It can happen, but not quickly or soon. Even setting that petty attempt to miss the point aside -- what asset class or combination of asset classes do you suggest as a replacement for equities in the event of a forex collapse?

[Joet]

I guess you're being pedantic now, don't let me get in the way. Also, not sure if China, Argentina, Brazil, Peru, Portugal, France, Thailand, countries in Africa, Nigeria, Australia, etc are considered 'eastern bloc', but lets just say the are. OK, then?

What does any of this have to do with forex btw? I don't think in any of those cases there was any problems with the exchange system itself, rather the individual countrys/currency.

If my points are considered petty, you are more than free to ignore my comments. I believe I already addressed your alternative question. Forgive me I suppose for not putting as much faith in backtesting as you do if you will.

[Bank]

Ah... I thought a more sophisticated point was being made here other than markets crash.  I've read some recent articles in the popular press (Economist) suggesting that the equity risk premium could possibly narrow in the future.  This was in regards to pension plan liabilities, and the articles did not reference academic studies, so I thought you were offering to provide the background on why and how.

Some time back, Basil Copeland wrote an article discussing the ERP, and arguing that a return premium over bonds was generally true, but not assured.  Particularly during periods of uncertain inflation (like we may be heading into?) risk premiums narrow, or even turn negative.

I found that article again on JStore, apparently called "Inflation, Interest Rates, and Equity Risk Premia."  I will try to paste the link in, but I'm not very technologically sophisticated, so don't burn my house if it doesn't work.  Seriously, I'm still paying for the house and I'd hate to lose it.

http://www.jstor.org/discover/10.2307/4478545?uid=3739256&uid=2&uid=4&sid=21102293431977

[daverobev]

Buy foreign bonds. Buy some precious metals (just a couple of percent).

The US is not the center of the world. Though, from outside, it does look like it's getting back on a moderately sensible track.. til next time.

I'm not saying "be a prepper" but... having the apparatus to make fire, having a backup if the electricity goes out (to heat your home), and so on, is not foolish. And having a small stockpile of food is also not foolish. IMHO.

[Johnny Aloha]

I've reduced my position in VCLT, which turned out to be a great investment - nice yield and nice appreciation.  I haven't completely sold out though.

Everyone probably has a different AA based on their risk tolerance, age, etc.  Bonds are supposed to be not-so-correlated with equities, so if you are trying to achieve risk managed returns, bonds should be a part of the portfolio.

I am sticking with my AA, which includes bonds.

[grantmeaname]

Some time back, Basil Copeland wrote an article discussing the ERP, and arguing that a return premium over bonds was generally true, but not assured.  Particularly during periods of uncertain inflation (like we may be heading into?) risk premiums narrow, or even turn negative.

I found that article again on JStore, apparently called "Inflation, Interest Rates, and Equity Risk Premia."  I will try to paste the link in, but I'm not very technologically sophisticated, so don't burn my house if it doesn't work.  Seriously, I'm still paying for the house and I'd hate to lose it.

http://www.jstor.org/discover/10.2307/4478545?uid=3739256&uid=2&uid=4&sid=21102293431977

Fascinating article! I would have preferred that the author spend a little more time on the empirical part of the paper, though -- just how bad does inflation have to be, and were the assumptions of the ratio of stocks' and bonds' inflation-tolerance reasonable? Three years after its publication, the equity risk premium was articulated. Looking for similar articles today, it seems that the larger equity premium puzzle remains unanswered, with everything from behavioral finance to black swan events compelling in models and less so in practice. With that much unclear, it's not surprising that little work has gone into the relative sizes of the ERP and bonds' inflation risk premium. Thanks for sharing, though!

[grantmeaname]

What does any of this have to do with forex btw? I don't think in any of those cases there was any problems with the exchange system itself, rather the individual countrys/currency

Sorry, the term is currency crisis. I switched some words around, and if that caused you any discomfort I apologize, but the operative mechanism of the 1990s' economic crises of Argentina, Mexico, Russia and the eastern bloc, Thailand, Indonesia, and South Korea, was a speculative attack by forex traders. As you correctly note, that requires a problem with the currency. Since we've got the currency that a solid majority of international trade is transacted in, it would take a dramatic shift for a currency crisis to affect the US. And again, even then, that's not an indictment of equities unless you've got an alternative asset class to replace them with. If all asset classes decline similarly, it doesn't damn stocks.

Forgive me I suppose for not putting as much faith in backtesting as you do if you will.

You have no clue how much faith I put in backtesting. I just said that it was meaningful and could provide information about the future, which is how we function in all areas of our lives. Anything beyond that is a straw man you stuffed yourself.

[tomsang]

Just thought this was a cool sample of our recent history. Guess what each of these notes has in common?
Backtesting your portfolio and basing future returns on it is about as effective as driving your car backwards.

I get it!!  All the various countries that had huge inflation and where bonds became worthless. If you owned equities or companies in these countries then your investment may still be intact. If you are assuming that we are going to have negative economic growth and start printing money like these countires over the next 40+ years then you should not plan on retiring. Bonds will be wiped out where equities have a fighting chance.

[sdp]

just buy tulip bulbs..... atleast you can cook em up and eat them like onion rings if you have to.  besides, a mundane and practical commodity like tulip bulbs? how could they cause a bubble, bet it would never happen...... just buy a stable real commodity and it will hedge against inflation..... Perfect, I'm buying some....

[chills]

just buy tulip bulbs..... atleast you can cook em up and eat them like onion rings if you have to.  besides, a mundane and practical commodity like tulip bulbs? how could they cause a bubble, bet it would never happen...... just buy a stable real commodity and it will hedge against inflation..... Perfect, I'm buying some....

I see what you did there :)

[davisgang90]

I've got about $1.5M-$2M in bonds (ok, not really, but I will have a military pension which is kinda like having a lot of T-bills).

[Bank]

Fascinating article! I would have preferred that the author spend a little more time on the empirical part of the paper, though -- just how bad does inflation have to be, and were the assumptions of the ratio of stocks' and bonds' inflation-tolerance reasonable?

I hear you.  One of my annoyances with academic articles in finance is that they often avoid the practical and interesting implications of their research.  In my opinion, the FAJ is one of the most grounded and it still typically falls short.  Journal of Finance articles are typically so far out there that they are virtually useless from a practical standpoint.  It's been a long time since Miller-Modigliani, CAPM, and Black-Scholes were changing the way we looked at the world.