Thursday, May 26, 2011

Bank shares - the new bonds?

Thinking about the future of the economy, not just short term but long term, what is likely to be the next bubble?

Right now, after doing some thinking, I'd say bank shares.

Why? Because they are the new bonds.

If the economy someone manages to get itself out of its current shape, if the US can avoid a default (oh, and if no other country default either) and maybe the growth of the deficit falls somewhat, then everything still isn't okay.

Shares are riskier than bonds. That's why they have to give higher return than bonds. Investors demand a so called risk premium, if they don't get that, they'll just keep their money in bonds.

The reason why bonds are riskfree is because they are guaranteed by the government, and governments in general tend to pay back their debts (with a few notable examples; such as Argentina).

So what do I mean by saying that bank shares are the new bonds? Because, by official decree since 2008, banks are now protected by the government in the same way bonds are. They officially cannot go bankrupt anymore, and so they are just as riskfree as the government bonds (which aren't exactly riskfree, but as close as you can get).

In 1999, a famous book was published named "Dow 36,000". It predicted that investors would soon realize that shares aren't risky at all and the whole "risk premium" thing would die. And once the risk premium was gone, shares would be worth thrice as much as they were back then, leading the Dow to rise to 36,000. This was during the height of the dotcom bubble.

The math, in itself, was more or less correct. If there were no risk premium, shares may very well be worth three times as much as they are. And since the banks are now protected by the government, why would anyone ask for a risk premium from them?

In effect, the bank shares have become government bonds. And therefore, once the economy actually does recover, their prices will become inflated and people will rush to buy shares in banks, treating them as a riskless asset with extraordinarily returns. Banks always go up during booms, and the government has now promised that they won't fall during recessions. So, win-win for investors.

Of course, the next banking crisis will be too severe for the government to handle, so the banks will go bust anyway - and when supposedly riskfree assets go bust, that's not good news for the market.

Just some thoughts. I'm sorry if this post is not as structured as most of my posts, I'm in a bit of a hurry.

/John G


Val said...


If you had money to invest where would you put your money?

BOSMAN said...

Hi John!

Welcome back.

How is your father doing?

John said...


I would be investing in commodities, just in general - that is, don't pick a specific commodity, that's too risky, just make a basket of commodities which should involve gold.

Also, invest in different currencies. Don't trade too much, just make sure you have SOME money that is not in US dollars, in case a default and/or high inflation sets in. Swiss franc, British pounds, hey, even the Swedish Krona is a good currency. The Russian Ruble as well - Russia is virtually debt-free so they won't be hit much even if there is a collapse either in the dollar or the euro and interest rates go up.

Bosman, thank you, it's good to be back. My exams are finally over (didn't go as well as I hoped they would, but at least they are over). My dad is still doing well (still active and everything), he has an appointment now with a surgeon in june, to discuss some stuff and prepare for the surgery they are going to do in the fall.

Revolution 2012 said...

Welcome back John as well.

Hope everything is working out for your dad.