No, we are not in a Bubble

A lot of talk on Wall Street on whether the stock market is significantly over-valued, that is, are we in a bubble.  Everyone has an opinion.  Including me.

People compare to the bubbles of 2000 and 2007 and see many of the same metrics in our current market.   And it is true that some of the same metrics are in place.  Particularly regarding the S&P 500.  The $SPY is at all time highs, is trading at 16 times earnings and has a historically high CAPE ratio.

The problem with this analysis is that is really wasn't the S&P that was in the bubble in those years.  The bubble was really in other areas and when it popped, spread to the S&P.

In 2000 it was the NASDAQ, particularly the internet tech sector.  The NASDAQ composite skyrocketed to 5,000 (it is still only recovered back to 4,000) and when it crashed, took down everything else, including the staid old companies in the S&P.

In 2007, it was housing that was in a bubble.  House prices escalated to ridiculous heights that couldn't be justified by rents.  Prices still haven't recovered to bubble levels in most areas.  The crash in housing brought down the big banks which were part of the S&P.  

Some bubbles don't have an impact on the overall market.  Gold has crashed (by any measure) from 1900 to 1200 with nary a hint of contagion on the broader market.  Years ago, oil when from $35 a barrel to $150 and back again.  There were some minor disruptions, but certainly not a crash in the general market.

Therefore, in my opinion, there currently isn't a bubble in any sector that will have a damaging effect on the general market.  It may get there, but right now, prices are going up in an orderly fashion.  If you are looking for a crash, find a sector that is way overpriced and see if it can blow up the rest of the market when it falls.

Should You Invest in a Volatility ETN?

Volatility is one of the most dynamic and misunderstood topics in investing.  There is a lot of interest in the VIX, but most people don’t know how it works.  It is called the best indicator of fear in the market, but that is only because there isn’t a better one.  You can find a good description of how the VIX is calculated, but essentially it is a measure of call and put buying of an instrument, usually the $SPY.   More put buying means a risk of higher volatility, and an increase in the VIX.

Several investment companies, including Proshares and iPath have created volatility ETNs (they operate just like ETFs) and investors can buy and sell them just like stock. 

The problem is that unlike stock, the ETNs lose value over time.  The $VXX, as has been pointed out by Adam Warner (@agwarner on Twitter) has decreased in value from $6,400 to its current price of under $45, a terrible return.  No one should invest in the $VXX for any term longer than a few days.

On the opposite side is an inverse ETN, the $XIV. This product takes advantage of the mechanisms that cause the decay in price of the $VXX.    It has had a 75% return this year on top of similar returns last year.  You will find it hard to get returns like that in any other investment.

Why not just put all your money in the $XIV, or the $SVXY, a similar ETN?

RISK, in all caps.

When volatility does go up, these products get killed.  In 2001, the $XIV was cruising along until the debt ceiling crisis in the summer.  Then it went from $19 on July 1 to a closing low of $4.91 on November 21, a loss of almost 75%. 

Let me repeat that.  A loss of 75% in less than five months. 

Most investors are not going to be able to handle that kind of loss.  Therefore, most investors should stay away from this product, or invest a small amount and watch it carefully for any signs of an increase in market volatility.  It is unlikely you will be able to finance your retirement with this kind of product. 

Professionals love these products because they are useful in hedging positions.  Using them as an investment is asking for trouble.  

What are “Mom and Pop” Doing?

One of the main tenets of stock market investing is that the professionals are market leaders, and retail investors are laggards.   The convention wisdom is that when normal people rediscover the market, it’s time to sell. 

Josh Brown, @reformedbroker, is quick to make fun of all sides of the market debate, and he had a tweet, “what are “Mom and Pop” doing today so I can do something different.  He is being funny, of course, playing off the idea that individuals are always late to the party when it comes to the stock market.

My tongue in cheek reply was “laundry.” 

As I thought more about it, it was more insightful than I even planned.  Mom and Pop aren’t thinking much about the market.  They don’t care if it has hit a top.  They likely don’t even know it is at an all time high.  If they look at their investment account statements, they know that they have more money than they did before, but they don’t think much about the why.   People I know are grateful for the bigger balances, but just assume it will go down sometime in the future and they need to keep piling money in so they will someday be able to retire. 

The lesson is, don’t take into consideration what Mom and Pop are doing.  They aren’t thinking about the market anyway.