| Bubble, Bubble, Toil and Trouble |
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| Saturday, 31 October 2009 03:24 | |
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It's Halloween—a celebration marked with children's Jack O Lanterns, witches' bubbling brews, vampires, and make-believe visions of doom. But this Halloween we're having visions about a different variety of bubbles and doom—the asset bubbles recently predicted by Dr. Doom, aka New York University professor Nouriel Roubini. If you need a refresher course on the concept of financial bubbles, we urge you to pick up a copy of our book, The Big Gamble. We've laid out the whole grisly horror story of bubbles from the Tulip Mania of the 1600s, through the dotcom meltdown, right up to and including the housing bubble that caused the economic calamity that we're still struggling through. But is there another one coming? Roubini seems to think so. Roubini got his nickname, Dr. Doom, because of his famously grim, but accurate, prediction of the financial maelstrom. He was the first to recognize that questionable lending practices were going to lead to the housing bubble. Unfortunately, he was a bit ahead of everyone else. He sounded the alarm back when most people were still caught up in the euphoria of a rising stock market and real estate values that seemed to have no ceiling, and back when credit cards were tossed around like play money. In other words, nobody wanted to heed predictions of doom and gloom when things seemed so rosy. But . . . reality bites! Now, after the shock of a long and painful bite of reality, the news is that the economy has finally experienced the first quarterly uptick in over a year. And with it comes murmurs that the recession is officially over. But history is, by nature, cyclical—we've been down this road before. Does that mean it's time to start bracing for the next financial cataclysm? Are we unwittingly planting the seeds of the next economic crisis? In our October 15 posting we wrote encouraging news about the DOW breaking 10,000 for the first time in 2009. But the real focus of that article was the falling value of the U.S. dollar. So, it makes us wonder if maybe Roubini is on to something again when he predicts that the falling U.S. dollar and rock-bottom interest rates could create a new asset bubble and lead to another, even worse financial disaster . . . and just when we thought it was safe to go back into the market. Roubini's concern is that investors around the globe have been borrowing deflated U.S dollars to purchase equities, corporate bonds, and other assets that pay a higher interest rate. It's essentially the practice known in foreign exchange circles as "carry trades," or purchasing a currency with a low interest rate and selling it for a currency with a higher interest rate, thereby allowing traders to make a quick profit on the spread. In the current situation, the demand for assets that are being snapped up has forced prices to rise at a faster pace than our economic fundamentals or growth prospects can support. Let's review: Over-inflated asset prices? Check! Prices not supported by underlying fundamentals? Check! Assets snapped up by those looking for a quick profit? Check! Does that sound familiar? It should. It has all the makings of an impending bubble. With US interest rates moving toward zero, traders are succumbing to the temptation to buy higher-yielding currencies from emerging nations that are benefiting from premium oil and commodity prices. Traders are placing many of these "bets" as short positions. We tend to agree with Roubini when he calls this a dangerous game. After all, US interest rates can't remain this low forever. What happens when a sustained recovery is established? The Feds will be forced to boost interest rates rapidly to stem inflation. And how long can overvalued oil commodity prices continue? Something has to give. When the US dollar starts to appreciate as foreign currencies depreciate, there's a quick unwinding as traders buy up the necessary dollars to cover their short positions. That unwinding could create a situation that amounts to a US dollar bubble—one not supported by any underlying economic fundamentals, but simply fueled by the need to cover all those short positions. Like all asset bubbles, this one will inevitably burst and potentially create enough damage to send the US economy right back into recession. That's the worst-case scenario. But other economists see it differently. They believe that these so-called "carry trades" could be laying the necessary groundwork for a recovery. What happens to the populace mindset when the DOW is on the rise? People get optimistic. They start spending; maybe they even start hiring. Or maybe not. We don't know any Halloween black magic to help us see into the future, but we can't ignore Dr. Doom's unsettling track record for accurate predictions. It's clear to us that this current market rally can't continue without solid economic growth to support it. Right now it resembles a V-shaped recovery—one that started at an all time high, took a nose-dive into a sharp low, and is now heading back up again toward a new high that will likely be short-lived. Meanwhile, it's important to be diligent and heed the signs of the next emerging bubble. If you need some guidance on doing that, our book, The Big Gamble: Are You Investing or Speculating is filled with tips to help you sort it out. |
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