Signs that we are in a bubble of some sort are getting harder to ignore. Recently we’ve been considering a position in one of the ridiculously cheap-looking VIX trackers such as VXX. Above is a 20-year chart of the S&P 500 index (white) and the CBOE S&P 500 Market volatility index (orange). I have to re-iterate that our focus is principally value-driven investing (as opposed to technical) with a heavy dose of our own judgement of sentiment; however, seeing these clearly defined bubbles around the year 2000 and 2008 is stunning. In 2000, we can observe the cleanest bubble with very evident and simultaneous inflection points between the S&P and VIX as the gap between greed and fear as we’ll call it reached about 70%. In 2007, we can see something far more interesting (and perhaps far more destructive) as there was a distinct lag of complacency between the pick-up in fear and the pull-back in greed (due to the likes of Michael Burry and Steve Eisman perhaps?), the absolute gap between the trough in the VIX and the crest in the S&P was an absolutely unprecedented 82%–the final, fatal inflection point several months later was still around 70%.
Now we come to 2011-12, what’s immediately apparent is that we have seen a 71% gap which was quickly corrected and are already back into a new 71% gap–so what does this mean? Well, I get two things from this; the first is that we are not in an economy that supports bubbles so rather we are experiencing bubblets. The second, and perhaps more fundamental is the nature of these bubblets–I have to begin with the caveat that it’s quite possible that these bubbles and bubblets are simply part of the normal business cycle and should therefore not even be considered as anything of concern. That said, I feel that the two previous bubbles were the result of far more tangible factors than these bubblets. The 2000 recession was the result of a bubble caused by exuberant speculation in an industry that was real (see more here). The 2007-2008 recession was also the result of a bubble caused by exuberant speculation in an industry that was real enough (it is real-estate no?) and a solid spoonful of complacency. This brings us to where we are today; either we don’t know what we don’t know (quite possible)… or we are having bubblets which are created purely out of expectation, sentiment and massive amounts of complacency. I would argue that these are the most difficult to predict and can result in the most violent evaporations of capital we have yet seen. Suffice it to say, we are definitely entering interesting times; Apple reaching a trillion dollar market cap much like Cisco in the 90′s and a bunch of ludicrously expensive IPO’s of firms which are expected to create cash flows at some undefined time in the future, looming energy volatility (though not necessarily due to Iran as everyone thinks), and a serious amount of complacency and lack of will from America to deal with its biggest threat (the American economy itself)–makes us want to check out soon and go explore some more uncharted lands such as Peru, Chile, Turkey, Indonesia, Vietnam, Thailand and Mongolia.
As an aside, the proportions of this “risk-on” trade we are experiencing have an uncanny similarity in both equities and fixed-income. This tends to happen only shortly before a correction in the amount of risk that’s been taken on. Here are the last 180 days with a side-by-side of SPX (S&P 500) – VIX and HYG (iShares iBoxx $ High Yield Corporate Bond Fund) - SHY (iShares Barclays 1-3 Year Treasury Bond Fund).