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Bubbles Bubbles Toil and Troubles

July 16, 2005

There's the housing bubble and the commercial office space bubble. There's the bond-market bubble and its two progenies, the junk-market bubble and the emerging-market-debt bubble. That nearly $2.50-a-gallon price you see at the pump has all the markings of an oil bubble. And the premiums being paid for all those corporate mergers and acquisitions are almost always coincident with the top of a stock-market bubble.

In fact, nearly every asset market you can think of is showing signs of bubble like behavior. The reasons for this behavior are quite clear: The global economy is awash in free cash. "There is a tremendous amount of excess liquidity around, and it is proving very hard to get rid of it,"

The possibility of a liquidity bubble around the world should be of serious concern but nobody seems to have noticed or if they have noticed they don't seem to care. To some degree, this excess liquidity is what you'd expect as a giant baby boom generation reaches its peak earnings years and begins to save more for retirement. But more assuredly a major part of the story is the stimulative monetary policies of the central banks around the world. Ever since the Asian financial crisis in 1998, the Bank of Japan has been pumping out cheap money in an attempt to revive the Japanese economy in a vain attempt to slay the Deflation Dragon. In the United States, the short-term interest rates that the Federal Reserve controls have been below the inflation rate for more than four years; that's four years of free money being pumped out to the select few. The biggest culprit of all, however, is probably the central bank of China, which, to prevent the appreciation of the Chinese currency, has had its printing presses working overtime to churn out all the Yuans needed to buy up all those dollars earned through exports.

FED maestro Alan Greenspan has argued that nobody can really identify a financial bubble until after it has popped, which was one reason the Fed did little to try to stop the stock market bubble from getting out of hand in the later 1990s. That sophistry was recently exposed when transcripts of Fed meetings from 1999 were released showing that Fed officials, including Greenspan, were well aware that they were dealing with a bubble of immense proportions. That is now belied, as it was then, by any number of objective indicators of the widening gap between the economic and market value of various assets.

Recently one Real Estate guru, issued a report showing how the gap between the monthly out-of-pocket cost of buying a home vs. renting it has been widening at an accelerating pace; Nationally, the gap on average is now 28 percent more expensive to buy than rent, while in hot markets like South Florida, San Diego and San Francisco it is more than 50 percent. In Washington, it's 55 percent more expensive to own than to rent.

The house market is so hot that we even have the equivalent of day traders. In a drive in from the Miami airport recently, all the driver would talk about was the million-dollar condos that were being flipped several times before construction was even completed. Five years ago, the talk was all about Nasdaq Dot.Coms.

David Berson, the chief economist at Fannie Mae, bemoans the sharp increases in the number of homes being purchased solely for investment purposes - up to 30 percent in some markets. One study by the National Association of Realtors estimated that 23 percent of homes in 2004 were purchased primarily for speculation.

The downtown office-building market is also red hot, even though, nationally, there has been little or no increase in rents. Most of the price escalation can be explained only by an expectation that price appreciation will continue at its current pace. This is a perfect example of the "Greater Fool Theory" since a normal positive return on capital cannot be achieved through Buying and then Renting.

Phil Verleger, the energy expert, brings a similar analysis to the recent run-up in oil prices, which he said is being driven less by fundamentals (supply, demand and the cost of replacing reserves) than it is by the upward pull of futures markets. He said OPEC and its silent partners, the major oil companies, know that they make the most profit when oil inventories are lean, and the best way to keep them lean is to keep spot prices higher than futures prices. Now that every hedge fund and college endowment is Invested (?) heavily in the futures market placing bets on higher prices, spot prices are following suit.

The current bond-market bubble was attested to by no less an authority than Greenspan himself, when he admitted he was puzzled by long-term interest rates that have failed to respond to the 2 1/4-percentage-point increase in short rates that he has engineered. Greenspan called it a "conundrum." I call it a speculative market driven by a world awash in cash, irrational exuberance and herd behavior.

More importantly its probably a flight to quality by the super rich, who are more interested in protecting their assets than they are in how much more money they can make; especially given today's valuation and risk reward ratios.

The "Carry Trade" is completely distorting the world's bond markets. A similar story is being told by the narrowing spreads between treasuries and riskier bonds - the interest-rate premium that borrowers have to pay over "risk-free" U.S. Treasury bonds. In the junk-bond market, spreads are near historic lows, with many new issues oversubscribed. In the market for emerging-market bonds, spreads that once peaked at more than 10 percentage points, at the time of the Argentine debt crisis in late 2001, have recently fallen to an all time low of 3.3 percentage points.

Is it too much of a stretch to argue that stock prices have again entered bubble territory. Certainly as a multiple of earnings, today's prices are only slightly below historic highs. But there is a strong sense of deja vu in seeing Banks and Wall Street investment houses tripping all over one another to provide gobs of money on easy terms to companies and private equity funds engaged in bidding wars for overvalued telecom and software firms. I also assign some significance to the fact that Warren Buffett, who correctly identified the last bubble, now has $40+ billion sitting in the bank, and except for utilities is unable to find acquisitions to make at reasonable prices.

I don't know whether the FED was right or wrong in not raising interest rates more than a quarter of a point at a time and in sticking to its promise of "measured" increases in the future but what I do know, is that it is silly and down right dishonest for the FED to continue to ignore the condition of asset and currency markets, in supplying inflation data and when making such decisions and explaining them to the public.

"Irrational exuberance" is the most-widely quoted phrase ever uttered by a central banker. It's usually repeated in a way that makes Mr. Greenspan sound like the Oracle Who Knew Better, who warned investors that the stock bubble would burst.

This is B.S. He never gave such a warning. As for what Mr. Greenspan DID say about the 1990s stock market, here's a far more definitive remark -- especially for him -- which has long since vanished down the memory hole:

  • "It has become increasingly difficult to deny that something profoundly different from the typical postwar business cycle has emerged in recent years. Not only has the expansion reached record length, but it has done so with far stronger-than-expected economic growth.... The process of capital reallocation across the economy has been assisted by a significant unbundling of risks in capital markets made possible by the development of innovative financial products.... There are few, if any, indications in the marketplace that the reallocation process, pushed forward by financial markets, is slowing."
  • The time was April 5, 2000; the occasion was "The White House Conference on the New Economy." Yes, Alan Greenspan had purchased a first-class ticket on the "New Economy" train, right as it was about to go off the tracks. Because "the expansion" had "reached record length," he assumed that it wouldn't derail. He was mistaken.
  • Why bring this up now?

Because, once again, Mr. Greenspan has issued a decree on one of the most important economic issues of the day, to the Council on Foreign Relations:

"A number of analysts have conjectured that the extended period of low interest rates is spawning a bubble in housing prices in the United States that will, at some point, implode.... But a destabilizing contraction in nationwide house prices does not seem the most probable outcome.... And even should more-than-average price weakness occur, the increase in home equity as a consequence of the recent sharp rise in prices should buffer the vast majority of homeowners."

Now, in that last sentence, substitute "stock values" for "home equity," and "investors" for "homeowners." Does it now have a familiar ring -- sort of like what investors were telling themselves as their NASDAQ-based "growth funds" were losing 80% of their value.

Not that anything of the kind could ever happen again in any other overheated market. Could It?


Aubie Baltin CFA, CTA, CFP, PhD.
Palm Beach Gardens, FL
[email protected]


16 July 2005

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