The word bubble, in the context of financial markets, gets thrown around a lot these days. Some of this is understandable considering the global economy was, and still is, recovering from the incredible recession of 2008-2009. Our senses have been heightened to watch out for what may be coming next. Regardless, the excessive usage begs the question: What defines a true bubble?
Getting Real With Inflation
Inflation is one of the oldest and most well known adversaries faced by investors. Simply put it measures the change in price of goods and services that we purchase or consume including food, fuel, utilities, housing, clothing, entertainment, etc. That being said, investors must achieve a rate of return in excess of the rate of inflation in order to improve their purchasing power.
Cost of Capital
Good businesses, by definition, earn more than they spend. Those that can’t or don’t simply cease to exist. A quick glance at any corporate balance sheet reveals a wide ranging list of liabilities including: wages and salaries, accounts payable, employee benefits, etc. But there is an additional liability not disclosed on GAAP compliant balance sheets: the cost of capital.
Cost of capital is essentially what a company must pay it’s investors for financing its business activities. It is roughly equivalent to the return an investor should expect to receive for investing in a company.
Over the past few years I’ve found myself having a recurring conversation with friends, colleagues and family members. Despite indications that the economy is healthy and moving along, it sure doesn’t feel that way, and it’s tough to identify exactly why. Consider the following US economic data from the end of 1999 through 2014
|Median Household Income||$57,843||$53,657||-0.5%|
|Real After Tax Corp. Profits||$523.1B (Q4)||$1,700B (Q4)||6.2%|
|Real Gross Domestic Product||$12,323.3B (Q4)||$16,151.4B (Q4)||2.0%|
|CPI (Inflation)||168.3 (Dec)||234.812 (Dec)||2.4%|
|Effective Federal Funds Rate||5.30% (Dec)||0.12% (Dec)||–|
|Source: Federal Reserve Economic Data (See Below)|
Many investors hold bonds or bond funds as part of a diversified portfolio. Bonds can be used to reduce portfolio volatility while providing a reliable stream of income. Given the current economic environment–near zero interest rates and persistent speculation about when and by how much they rise–the risks taken in the fixed income arena are an appropriate subject to review.