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Three Things I Think I Think – Bubbles Edition

Here are some things I think I am thinking about:

1) Is there a bubble in passive investing? Michael Burry of Big Short fame, says there’s a bubble in passive investing. The basic argument is that passive investing has skewed the markets and caused small cap value stocks to underperform. Burry, unsurprisingly, is invested in many small value stocks. Soooooo.

This seems to happen once every few years where an active manager blames index funds for their performance. They’re an easy scapegoat, but as I’ve discussed previously, these arguments are mostly nonsense. Aside from the fact that “passive investing” isn’t even a homogeneous thing, there’s the fact that passive investing couldn’t even be a thing without more active investors. So this discussion doesn’t even make sense from the start. But the weirder thing here is that small caps have done just fine over the long-term. On a 10 year basis the Vanguard Small Cap Index has beaten the S&P 500 by 13.5%. So maybe Burry should have just bought…the Vanguard Small Cap Value Index?¹

2) Is there a bond bubble? Regular readers know that I have a history of debunking the idea of a bubble in bonds. I’ve long stated that inflation is likely to remain lower for longer and that the risk of a 1970s style surge was highly unlikely. So I was intrigued by Paul Krugman saying that the current collapse in rates is a potential bubble. He seems to be politicizing the environment a little bit saying that the yield curve inverted because faith in the Trump recovery has collapsed. But if there’s a bubble then doesn’t that imply that interest rates will surge (causing bond prices to collapse) and doesn’t that mean that investors are irrationally bidding down rates?²  Hmmmm. Maybe we shouldn’t mix politics with investing research!

3) About politicizing those rate declines….The big story of the week was this Bill Dudley piece on the Fed and Trump. The basic gist of the argument is that Trump’s trade position is so wrong that the Fed should hold rates and let the economy do what it’s going to do. My guess is Dudley thinks the economy will weaken and then Trump will have to own his trade mistake.

Honestly, I think this is a terrible idea. The Fed is independent for a specific reason – because we expect politicians to make short-term decisions that will often be political in nature. I fully expect Trump to want to stimulate the economy during his term. That doesn’t mean the Fed shouldn’t try to offset this stimulus to some degree if it’s creating risks. Likewise, if politicians do things that could hurt the economy then the Fed is there to operate in a countercyclical manner to offset that political decision.

Look, I’ve been super vocal about Trump’s trade position. I think it’s very dumb. But that doesn’t mean the Fed should stand by idly and let the economy weaken. That would contradict one of the main goals of the Fed’s independence.

¹ – I liked this post by Josh Brown who points out that the real bubble is in high fee active management. Yessir!

² – In fairness to Krugtron, I actually do think bonds are riskier than usual here. But as I’ve stated on several rare occasions in the last 10 years, it’s better to call these environments frothiness rather than bubbles. After all, bubble implies a very significant decline in prices which implies a significant rise in rates. I am more inclined to argue that rates could adjust higher, but are unlikely to surge to levels that would constitute a 30%+ decline. Maybe I should write something more detailed on this in the coming weeks???