Bubble, oh Bubble

I remember once the former Fed’s Alan Greenspan said it was impossible to tell a bubble while you were in it.

Review – the Standard & Poor’s index is up 58% from its March lows, gold has finally broken through the 1,000-an-ounce level and may go higher and bond yields have fallen substantially in spite of the huge US budget deficit. Is it too difficult to tell if we’re in a bubble?

What is really tough is trying to figure out how to invest while it is developing.

It is no wonder right now why I have been recommending investments in gold and other hard assets. When current Fed Chairman Ben Bernanke doubled the monetary base ina few weeks last fall, it was pretty obvious that the extra money would appear somewhere, either as zooming asset prices or as surging inflation. If gold is adjusted for inflation, it remains far below the inflation-adjusted equivalent of their 1980 peak, which would be around $2,300 per ounce today. Likewise, silver prices are even further below their 1980 peak, which would be around $130 per pounce or nearly 10 times the current level. The potential run-up is considerable.

Let us look at stocks. Let’s say the market of early 1995 – when the Dow Jones was at 4,000 – a reasonable base for estimating a fair value for the US stock market, then we inflation the Dow in line with nominal gross domestic product to keep it at fair value, which would bring us to a current day estimate of 7,800. To reach this fair-value level, Dow would have to drop 1,984 points or 20% - enough of a decline to qualify as an official bear market. But one thing to remember – 1995 wasn’t a bear market and economic and earnings prospects that year were really good. In another word, US stocks are overvalued. Even after the bearish trauma of last year, we remain in a stock market bubble.

Bubble investing is different from bull-market investing. There are not many ‘good’ values, so you have to be very careful. One should certainly keep much higher cash reserves than normal. Get ready to sell at the first signs that the Fed is beginning to take inflation seriously. You will know when this is because you will likely start hearing a lot of Fed ‘exit strategies’. Don’t be greedy – better to sell too early than too late.