Friday, May 25, 2007

Bubbles, Bubbles Everywhere...

The noted money manager Marc Faber recently said in a Bloomberg TV interview that he sees asset bubbles everywhere: stocks, bonds, commodities, precious metals, real estate, art, wine. The only asset he perceives as reasonably priced is real estate in Detroit and farmland, so he urges everyone to learn how to drive a farm tractor.

Naturally, the numerous concurrent asset bubbles are primarily a sign of the massive global bubble in "money": the unprecedented liquidity caused by massive US deficits and powered by low real interest rates. All this debt-created money is further pumped up by speculative leverage (e.g. yen carry, derivative sales, etc) and all of it together is being flung onto every asset there is, in an attempt to maximize trading gains.

And therein lies the first paradox: on a risk adjusted basis plain old cash is a rather attractive right now, what with dollars yielding 5.25%, euros 3.75%, sterling 5.5% and even yuan 3.06% and rising. Is that so bad? Only in a context of expectations of continuous double digit annual returns: i.e. there is a concurrent global bubble in greed, too. (Let me put it this way: It is estimated that profits for S&P 500 companies will grow by about 7% this year, around 2% over cash. Is that worth taking the added risk?)

The yen is admittedly still a horror show at 0.50% and if there was a prize given for the world's most inept central bank BOJ would have won it every single year since the late 1980's (I am being unfair here, but only a little). I mean, those guys have let their once proud currency become the cheapest harlot in global finance: everyone is enjoying the yen's services and paying next to nothing. (The clients are not using any protection, either, so next it's going to be the pox for everyone, but this is a family oriented site, so enough said.) Cheap loans in yen are used as a booster rocket for global liquidity to achieve even higher marginal rates of return, at the cost of yet another layer of risk, of course.

And there is a second paradox: as money pours into the market, the perception of risk - at least as measured by credit default indexes - is reduced, instead of going up. Credit default swaps (CDS) were initially created as a means of transferring credit risk between parties, but they have now become an asset class by themselves (eg CDO's backed by CDS's) and they, too, have benefited tremendously from the increased liquidity. Therefore, their current prices are not reflective of fundamentally lower credit risk, but of their high demand as assets to create all kinds of structured securities.

In sum, we have concurrent bubbles in liquidity, greed and risk-perception. They are highly correlated to one another and have created a bullish momentum that feeds on itself, mostly ignoring fundamental economic and geopolitical realities (e.g. US slowdown, China's manufacturing overcapacity, Iran tensions...).

In their final stages all bubbles create their very own "bubble-reality"; when they pop the "real- reality" takes over and leads to collapse. Today's most dangerous bubble-reality is the firmly held conviction that there is so much liquidity that all assets MUST go up. This is a delusion.

4 comments:

Edwardo said...

Mark my words, the final party is going to end this year. In fact, I think we are about to experience a global stock market correction before the final rally occurs later this summer. What I can't tell yet is whether we will rally into new highs or whether the correction will be deep enough that the rally will fail to take out the recent highs. In any case, based on various data, the whole mess has no more than five months to run. Then, what you have warned about for a long time, namely Peak Debt, will rear its ugly head like no body's business.

Anonymous said...

Hi Hellacious,

The number of smart bears has grown tremendously over the last two years.

A lot of people agree 100% with what you, Bantham, Faber, a seasoned list of austrian-minded economists plus a quite a number of anonymous blogger and forumers (the main French-speaking CAC 40 discussion list is 80% "intellectually full bear". A lost of us have indeed lost some money shorting a bit ahead of time...).

The no-tongue-in-cheek Trichet should not be forgotten in this list. He has been extremely clear about a significant "re-pricing" of assets during the Davos event.

The output looks clear to most of them, a significant market adjustment of all class of speculative assets, i-e most of them will take place.

At least if the choice is not made to let the currencies drop wildly. Nearly impossible in Europe because of the constitutional set-up for the ECB and the balance of power within the Zone.

Well concerning the Fed, it looks like the inflationary option is still there. At least on a longer run.

The only key point is now when and how will these adjustements take place? This may of course depend of the class of assets.

Stock markets tend to crash whilst real estates ones may move à la japanese. It looks like the housing market down trend has started in a series of the key bubbly markets (the US, Spain).

So it looks like the only remaining issue is: when will financial markets start to adjust and how?

François

Alex Zeissig said...

Based on current debt levels and the record amount of highly leveraged investments globally, the world's financial system is no longer positioned to withstand even a minor recession.

In the event of a widespread slowdown in global economic growth, the resulting deflationary forces and accompanying debt liquidation will bring about massive dislocations in the financial markets and their underlying economies.

We will likely witness the value of traditionally uncorrelated asset classes in diverse geographic regions dramatically decline in lock step. This outcome will totally belie the notion that derivatives and other financial innovations have somehow efficiently distributed risk in a fashion that promotes long term financial stability. To the contrary, the Great Moderation will be suddenly tranformed into the Great Unwind.

Just as it is impossible to determine which snowflake is the one that finally sets off the avalanche, it is virtually impossible to predict what will be the final triggering event. It could be any of a number of the usual suspects including the continuing saga of the subprime mortgage market in the US, a geopolitical crisis in the Middle East, or the bursting of the equity bubble in China. Regardless,once the conditions are right even the most normally insignificant and mundane event can become the final catalyst.

Anonymous said...

The fact that the financial system, throughout the world, had to take asset inflation and debt assumption to such great lengths, proves that they have been running from a debt deflationary contraction for most likely the good part of the last decade (Milton Friedman says it has been since 1932). Ultimately, it is impossible to avoid the inevitable reconciliation of such credit excess.