Wednesday, November 29, 2006

Forever blowing bubbles

"I'm forever blowing bubbles, Pretty bubbles in the air
They fly so high, nearly reach the sky
Then like my dreams they fade and die."

I'm Forever Blowing Bubbles - Jaan Kenbrovin & John William Kellette 1919.

With all the talk about financial bubbles these days, we might start to get comtemplative and ask ourselves a couple of basic questions.

First, what is a bubble? And second, have the conditions that define a bubble been shown to exist in one or more areas of the economy? Are we in fact living in a "bubble economy", or is the term being indiscriminately applied to any phenomenon where rapid growth and speculation have been observed?

Let's begin by defining our terms. A financial bubble is properly defined as a situation in which the market for an asset or valued object has been taken over by rampant speculation, with increasing disregard for the underlying economic fundamentals.

In Manias, Panics, and Crashes: A History of Financial Crises, Charles Kindleberger outlines the process by which financial manias become financial panics. He describes a recurring pattern in which easily available money and credit fuel increasing investment and speculation. This cycle feeds off of itself, to a point where the expectations of the speculative boom are no longer pinned to reality.

Thanks to M.A. Nystrom for providing the following Kindleberger passage:

The object of speculation may vary from one mania or bubble to the next. It may involve primary products, or goods manufactured for export to distant markets, domestic and foreign securities of various kinds, contracts to buy or sell goods or securities, land in the city or country, houses, office buildings, shopping centers, condominiums, foreign exchange. At a late stage, speculation tends to detach itself from really valuable objects and turn to delusive ones. A larger and larger group of people seeks to become rich without a real understanding of the process involved. Not surprisingly, swindlers and catchpenny schemes flourish.

At some point, the value of the sought after object is called into question and the crowd begins to realize that there is no real substance underpinning their investment. The bubble bursts and the cycle is complete. A similar pattern is described in Edward Chancellor's book, Devil Take the Hindmost: A History of Financial Speculation.

So now that we know how a bubble works, the question becomes: are we currently experiencing one or more bubbles in the financial markets? This question has recently been taken up by more than a few writers. We'll reproduce some of their views here and get an idea of where we stand.

I should note at the outset that I would not bother to examine the arguments of those who failed to identify the previous market bubble, the Nasdaq telecom and technology share mania which ended in 2000-2001. While I am open to the dissenting views of any informed commentators, I would be loath to follow the advice of anyone playing the role of "market cheerleader". On to the good stuff...

"There is nothing better than a good bubble", says Financial Times columnist James Altucher. In this recent article, Altucher disregards the current obsession for labeling bubbles and focuses instead on the values he is finding in the shares of America's leading companies.

Rather than be put off by talk of a resurgent bubble in the Dow Jones Industrial Average and its large cap, blue-chip components, Altucher is looking for relative value. He says that the average is being led higher by a small group of stocks while most have lagged behind.

Many of these shares, he claims, remain attractive. He cites Microsoft, Disney, Verizon, and Wal-Mart as examples. Despite poor performance in the post-2000 bubble contraction, Altucher feels that these large-cap shares will follow the Dow higher in the future.

Surprisingly, this is a view that was recently shared by none other than Dr. Marc Faber. In the September 22 article, "Dr. Doom turns bullish on U.S. large cap stocks", Marketwatch picked up on the news of Faber's favorable near term outlook for American large cap and technology shares. While Faber had taken a largely cautious stance on all asset and investment markets, this news provided a bit of a reprieve for the U.S. market.

Still, the news of Faber's bullishness also carried the message of a pessimistic long-term outlook for the dollar and U.S. economy relative to Asia. Dr. Faber's latest message to investors is this: do not expect the Fed to bail out the economy time and time again with ample liquidity.

The notion among investors has again arisen that the Fed will soon cut interest rates and support the economy and asset markets with monetary policy measures. I believe that, sooner or later, this scenario is very likely, but instead of boosting the real economy and asset prices in the US, it will lift precious metals, commodities and foreign assets further.

The point that Faber makes is that further liquidity injections will likely spill over into the speculative arena. Instead of successfully propping up the economy and housing market, the money will find its way to the markets that are already bouyant and getting ready to rocket higher. Be sure to read all of Dr. Faber's recent writings for a better understanding of these trends.

Jim Puplava provides an interesting overview of how monetary and fiscal policy gave rise to asset inflation in an article entitled, "The Two Bens". Citing the arguments of Debt and Delusion author Peter Warburton, Puplava describes how central banks put forth a prescribed set of solutions for government to combat inflation in the 1960s and '70s. These actions provided the impetus for subsequent asset inflations/bubbles that we still refer to as "bull markets".

The advice given was three-fold; raise short-term interest rates, cut government spending, and finance the deficit through the issuance of debt to foreign and domestic investors.[7] Instead of monetizing debt, governments turned to the international bond markets to finance their largesse. Deficits still grew along with government spending. The difference was that inflation was transferred to the financial system.

The result was a bull market in paper in both stocks and bonds. Central banks still monetized debt, but not at the same pace. The money supply still expanded and currencies still depreciated, but we no longer called it inflation. The new term was asset bubble as we went through asset bubbles in farm land, oil, stocks and real estate in the 1980s. This was followed by additional asset bubbles in foreign bonds, emerging markets, U.S. stocks, especially technology stocks in the 1990s. In this century we now have asset bubbles in bonds, mortgages, real estate, stocks and in consumption, as reflected in a rising trade deficit.

And lastly, we should look to recent events in the mergers and acquisitions arena and the latest wave of leveraged buyout activity. The most recent string of deals have moved some people to suggest that the private equity led LBOs represent a bubble in themselves, or at least a highly visible sign of an ongoing credit bubble worldwide.

For more on this, see the writings of Doug Noland, who has been chronicling the dynamics of a "credit bubble" for some time.

As you will see in the writings of Doug Noland, Marc Faber, and others, a worldwide expansion of money and credit can spill over into other areas of the economy, fueling speculation in any number of items. Repeated efforts to "save" the economy from the course of a normal boom and bust cycle, through liquidity injections, disrupts markets and may give rise to a bubble economy.

In such an environment, one ready-to-burst bubble will be swiftly replaced with another asset bubble in an attempt to "keep things going". We have already seen this process at work in the mortgage finance and real estate bubbles that replaced the deflated stock market bubble of 2000. Only time, and a careful investigation of the facts, will tell us when and where the next bubbles will appear.