History shows us what's a bubble and what's not

Seldom do prices in the UK government's debt market peak at the end of a month. However, on the 31 August, 2010 they did just that and pushed the Aureus Crux Investment Club's unit price to a new all-time high of £2.77. But is August's all-time high in the club's unit price going to be its swan-song?

It could be, if the Cassandras in the financial community warning of dire consequences of a bond bubble are correct. However, if we look at past occasions when, from the perspective of that age, bond bubbles may have been in the offing, and note their outcomes, it could give us a better understanding.

For example, when yields on ten-year US Treasury bonds fell to 3.25 per cent just after the Dow's nadir on 8 July, 1932, this was as low as they had been during the whole depression. Bonds could have seemed in a bubble from this standpoint.

If, however, you follow the yield curve and the Dow's progress, you will see that by the middle of 1935 the Treasury ten-year yield had fallen through 3 per cent, much less than the previous low, even as the Dow rose by 180 per cent, before the yield started to rise again. So 3.25 per cent was not a bubble at all.

Japan's recent economic history saw interest rates decline fairly steadily from just over 8 per cent, a year after the Nikkei hit its all-time high on the very last trading session of 1989, to 2 per cent, seven years later. Now, that is what I call a bubble. Wrong again. Yields have remained at that level or below for an unprecedented 12 years and currently are actually falling towards 1 per cent.

When our FTSE-100 topped out at 6,732.4 on 15 June, 2010, the 10-year gilt yield was 5.5 per cent. By January 2009, when the FTSE was nearing its 2009 low, the ten-year yield fell to 3 per cent. As the FTSE recovered, the 10-year yield once again rose back above 4 per cent. In the FTSE's most recent dip the yield fell to 2.9 per cent.

Therefore, if we compare the UK's current 10-year gilt yield to the US Treasury yield in the 1930s, then we could be in a bubble. But if you compare it to the Japanese experience, we are nowhere near a bubble. It is, therefore, very difficult to know when a bubble is not a bubble.

In general terms though, the bond yield tends to fall as the main indices fall and vice versa. Therefore, the club's paper and pencil analysis (papa) has to determine the direction of the FTSE and this will dictate whether the club loads up with more bonds or sells out and the bond bubble has burst. This month papa is still looking for a decline in the FTSE. Although, if the FTSE climbs above 5,538, as seems likely, and proceeds to breach its 5,825 high of 15 April, 2010, the Club will be in the wrong investment at the wrong time.

But if the FTSE breaks down below its 200-day moving average at about 5,350, and then breaks below 4,805, the Club is back in the right investment vehicle and the bond bubble has not burst.So is the answer to the conundrum "when is a bubble not a bubble", when it doesn't burst?