Is The Dow Jones Industrial Average In Bubble Territory?

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July 17, 2017 6:32am INDEXDJX:.DJI NYSE:DIA


From Streetwise Reports: Rudi Fronk and Jim Anthony explore the connection between market bubbles and the price of gold.

We thought that when the gold price broke above its five-year downtrend in early June, it would establish an upward trend. We were wrong. Another false start, it seems. The bubble in financial assets continues.

We think understanding bubbles is the key to discerning the big moves in the gold price. The west has documented seven financial manias or bubbles in the last 250 years. These bubbles peaked and then collapsed in 1720, 1772, 1825, 1873, 1929, 2000 and 2008. In every case, gold performed relatively less well in the expansion years of the bubble and outperformed every other asset class in real terms in the contraction phase.

In the recent manias, we also know that gold stocks substantially outperform gold during the contraction phase because operating costs fall.

Let’s look at the recent examples. In 2001, the mania collapsed and gold soared to new highs. In 2008 a bubble in housing led to a collapse of the financial system and once again gold took off to new highs. In 2012, the Fed succeeded in creating yet another bubble in stocks and bonds after dropping rates to zero and flooding the system with liquidity via an alphabet of programs, chief among them QE (quantitative easing). Gold performance has since fallen well behind stocks and bonds in the expansion phase of the current mania.

As we have often noted, gold is the ultimate risk-averse protector of wealth. And bubbles are the ultimate expression of risk-taking. Risk-taking is still the order of the day.

What’s a bubble?

Bubbles are periods of widespread high-risk investor behavior marked by extreme valuations and extremely bullish sentiment unsupported by economic facts, ending in a crash. Bubbles have three necessary components:

1) A credit boom: Investors use large amounts of leverage to enhance returns. Investors reach for yield. Debt substantially increases risk. The results is forced liquidation and a liquidity panic when markets fall.

2) A narrative: The extreme valuations are explained by a narrative that says “this time is different.” The bubble was supported by the expectation that Internet technology would drive a New Economy of faster growth, amazing productivity gains and higher profits. The housing bubble was supported by the supposed fact that housing prices could not fall, that a national housing bubble was not possible and that a new paradigm of risk-reducing, AAA-ranked MBS could virtually eliminate risk. Today’s everything/everywhere bubble is supported by the supposed ability of central banks to manage their economies and mitigate financial system risks by keeping interest rates very low and liquidity very high.

3) Time: The third element is a long period of growth, with no recessions, low market volatility and accommodative monetary policy. Hyman Minsky noted in his Stability Hypothesis that the longer the period of economic and financial stability, the greater the resulting instability. Recessions especially clear the system of unproductive debt and the deleveraging reduces risk. Otherwise, Hedged Finance (in which debt is backed by a growing ability to repay) is followed by Speculative Finance (in which debt must be rolled over but the interest is covered by earnings) to Ponzi Finance (in which the interest is paid from fresh borrowings). That’s why bubbles always occur near the end of long economic expansions, when the economy is already slowing down but risk-taking is at its peak.

The key question to be asked now by investors is whether or not financial markets are truly in a bubble or just a wild bull market. These alternatives reward very different strategies. We will provide our view in the next installment.

The SPDR Dow Jones Industrial Average ETF (NYSE:DIA) was unchanged in premarket trading Monday. Year-to-date, DIA has gained 9.49%, versus a 9.86% rise in the benchmark S&P 500 index during the same period.

DIA currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #5 of 76 ETFs in the Large Cap Value ETFs category.

This article is brought to you courtesy of Streetwise Reports.

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