Who's Blowing This Bubble - And When Will It Pop?

By Simon Johnson

Matt Taibbi has rightly directed our attention towards the talent, organization, and power that together produce damaging (for us) yet profitable (for a few) bubbles. Most of Taibbi’s best points are about market microstructure – not the technological variety usually studied in mainstream finance, but more the politics of how you construct a multi-billion dollar opportunity so that you can get in, pull others after you, and then get out before it all collapses. (This is also, by the way, how things work in Pakistan.)

In addition, of course, all good bubble-blowing needs ideology. Someone needs to persuade policymakers and the investing public that we are looking at a change in fundamentals, rather than an unsustainable and dangerous surge in the price of some assets.

It used to be that the Federal Reserve was the bubble-maker-in-chief. In the Big Housing Boom/Bust, Alan Greenspan was ably assisted by Ben Bernanke – culminating in the latter’s argument to cut interest rates to zero in August 2003 and to state that interest rates would be held low for “a considerable period”. (David Wessel’s new book is very good on this period and the Bernanke-Greenspan relationship.)

Now it seems the ideological initiative may be shifting towards Goldman Sachs.

As Bloomberg reported on August 5th, “Goldman economists, led by Jan Hatzius in New York, now see a 3 percent increase in gross domestic product at an annual rate in the last six months of this year, versus a previous estimate of 1 percent. The new projections were included in a research note e-mailed to clients.”

Goldman’s public thinking, of course, has been that we face such slow growth that interest rates should be kept low indefinitely. There is, in their view, no risk of inflation – and no such thing as potentially new bubbles (e.g., in emerging markets). The adjustment process will go well, as long as monetary policy stays very loose – it’s back to Bernanke’s 2003 line of thinking.

This line of reasoning has been very influential – reinforcing Bernanke’s commitment not to tighten monetary policy in the foreseeable future and fitting in very much with the Summers model of crisis recovery. Just a couple of weeks ago, in his July 14 report, Jan Hatzius argued, “further stimulus remains appropriate” and “the appropriate debate is not whether fiscal and monetary expansion is appropriate in principle but whether it has been sufficiently aggressive.” I don’t know if he has revised this line in the light of the big upward revision in his growth forecast or whether he is still saying, “Ultimately, we do expect further stimulus, but it may take significant disappointments in the economic data and the financial markets before policymakers move further in this direction.”

Much faster growth than expected is, of course, in today’s context a good thing. But it also brings complications. If you keep monetary policy this loose for much longer, you will feed bubbles. And if you encourage even looser monetary and fiscal policy, there will be a costly reckoning not too far down the road.

Monetary policy orthodoxy under Greenspan did not care about bubbles in the least. Now we (led by Greenspan) have massively damaged our financial system, our real economy, and our job prospects, this view is under revision.

Of course, in principle you should tighten regulation around lending but, just like 2003-2007, who is really going to do that: the US, China, the G20? On this point, all our economic leadership is letting us down – although they are getting a powerful assist from people like Goldman (and Citi and JP Morgan and almost everyone else on Wall Street.)

Next time, our big banks will take another massive hit – quite possibly bigger than what we saw in 2008. Goldman and its insiders are ready for this. Are you?

Comments

[Swashbuckler:]

If you make your living soley from investing, you are obviously pretty bright. But keep in mind, there were many bright people who made their livings soley in real estate or mortgages, right up until this past year when they were carried out in body bags. And although you probably write an excellent investment newsletter, they are for the most part a dime a dozen, my 11 yr old niece is thinking of writing one. No sense in fighting the trend to the upside, but if the market heads south you'd better get out of the way. peace.


On Aug 08 04:38 PM dividendmachine1 wrote:

> As a person who makes a living solely from investing and writes an
> investment newsletter ,I can say that this market has much more upside
> on it
>
> Just buy the right stocks at the right price.peace

Aug 08 05:35 PM

[Donkey Kong:]

"Don't look now, but the discount rate is awfully low. You guys took math, right?"

When you use a low discount rate, by definition you are receiving a low return. I thought the idea was to generate HIGH returns, Mr. Math?


On Aug 07 07:44 PM Deepv wrote:

> Where is the bubble? dell on 10x earnings? China -- fine. Show me
> the bubble! I thin you all need to get a grip and learn stock = PV
> of future cashflows. Don't look now but the discount rate is awfully
> low. You guys took math right?

Aug 08 06:22 PM

[robert.b.fe...:]

Can you say Cap and Trade?


On Aug 08 09:45 AM FB5000 wrote:

> ok. so the glass is a quarter empty. I get it. any positive news
> is discounted. what's happening isn't real. it's a bubble. etc. etc.
>
>
> the market is now back at pre-Lehman levels. we enetered recession
> in Q3 2007 it was a fairly orderly and normal slowdown - then we
> hit Lehman. It became a rout. Q4 2008 demand collapsed. etc. etc.
> world trade cut by 30%, negative gdp. no bank lending, fear, panic
>
>
> ok. then the policy response. goal avoid depression. buy time to
> let the economy heal.
>
> avoid deflation - lower rates/quant easing
> support institutions - tarp and other
> kick-start - stimulus (btw - very little of this is "in the economy"
> yet)
>
> all approriate and necessary
>
> present day. glass 3/4 full. so far so good. freefall ended, growth
> is back - GDP will be positive from here on out, recovery is here,
> employment will follow. world trade has upticked, maybe it is just
> inventory restocking we'll see. demand is not back but from these
> levels the consumer does not need to go back to pre-lehman levels,
> people are saving - that's actually a positive - over time deleveraging.
> No inflation and little prospect for now, protectionism seems to
> be at bay, fiancials are healing - they will lend one day, spreads
> are approaching or are at pre-lehman levels
>
> glass 1/4 empty. government spending. it must be kept in check, taxes
> will rise- they have to - the Bush tax cut was not sustainable -
> back to Clinton levels. we need fiscal responsibiity. a second stimulus
> is not needed - it would be too much. commercial property. retis
> are improving and capital is flowing in but I worry about the sector.
> Does Obama suport free trade - he needs to step up and get Doha done.
> that's critical.
>
> summary for stocks. it is a benign environment - steady if unspecatular
> growth, low inflation, little cost pressure, they will drift up,
> US big caps are cheap, some emergings are cheap, REITS are still
> cheap, there are opportunities out there. We should get a pullback
> maybe we go back to the high 900's then higher - look for 1200's
> to 1300's next spring after that anything is possible - will depend
> on the Fed if inflation and interest rates start to rise then we
> will see correction maybe take 10% off then up again.
>
> That's all.
>
>
>
>
>
>
>

Aug 08 06:29 PM

[Fat Squirrel:]

I've never understood some people's slavish and superficial reliance upon earnings multiples as an indicator of value. Under normal 'equilibrium' conditions, perhaps they offer some useful insight into relative value, but in a situation where company top lines are dependent upon government spending to an unprecedented degree, isn't the real question "how stable is stimulus-derived demand"? Or "what are threal e consequences of stimulus-induced demand shifting?"

Several examples of this immediately spring to mind:
1) Bank earnings seem to be largely manufactured now through 'trading profits', newly-created accounting gimmicks, deferring the realization of loan losses many times capital, and back-door infusions of government (taxpayer) capital through above-market derivatives transactions (eg AIG -> GS, etc). To say, on the basis of current “earnings” and historic multiples, that financials are cheap seems to completely miss the point that the “earnings” to which these multiples are being applied are completely unsustainable and of exceptionally low quality.
2) The much-ballyhooed 'low multiples' of emerging markets seem to completely overlook the fact that the Chinese government's stimulus (and the consequential wave of private borrowing and demand front-running in commodities) has caused a similar artificial spike in earnings. To apply normal multiples to these puffed-up earnings seems like a fine way to overpay for stocks.
3) The Cash for Clunkers deal is another classic example of pulling forward future demand into the present. Yes, it makes the current period's numbers look great, but only at the expense of prolonged *depressed* future demand. What do we do after the sugar high has passed and we're stuck with protracted subpar sales in coming quarters? These programs do not create new demand, they just change its timing.

The Green Shootists who love to extrapolate the stimulus-induced sales and earnings increases indefinitely into the future and to then cite these as evidence of a "recovery" are, at best, suffering from severe cases of confirmation bias. Crowd psychology and the expression of people's vested interests are also playing a significant role here.

As earlier posters have pointed out, stocks are supposed to be priced at a risk-discounted present value (PV) of future cash flows, but under the present circumstances we really need to consider just how stable current "sales", "earnings" and, by extension, cashflows are given the gargantuan distortions introduced by aggressive government interference in the economy.

Also, a key determinant of PV is the discount rate applied to future earnings. The lower the discount rate, the higher the PV (and hence the higher the theoretical value of a stock with an assumed future earnings stream). But this is fraught with problems:
1) The usual way to select a discount rate is to take a “risk-free” rate (eg treasuries of a comparable term) and then to add a “suitable” risk premium. But Treasury rates are currently being manipulated down (QE) and are at multi-decade lows. Is it really wise to use these artificially-lowered base rates when discounting future earnings to arrive at 'fair' stock prices?
2) Interest rates (and by extension discount rates) are also a function of inflation expectations. Given the apparent love affair of central banks around the world with historically unprecedented money printing, shouldn't we expect much higher inflation a few years hence? If so, then the discount rates we apply to longer term earnings streams need to be MUCH higher (would would greatly reduce the PV of future earnings and of theoretical stock prices).

Sitting out a huge manic market spike is admittedly painful, and trying to time its end by going short is doubly so, but I'd urge people to really focus on the sustainability of the underlying forces driving the apparent improvements being used to justify the continuation of the current market mania both here and abroad.

Aug 08 08:01 PM

[Casualbrain:]

The market will do what the market needs to do. All I know is that I'm still positive alpha right now because of this recent runup. I've quit shorting the market because the losses were too high but continue to cover with options just in case. Now 90 percent in equities. I didn't get in at the bottom but waited until May/June and current returns for the year are in the 25 + percent range and well above the average hedge.
There is no way to tell if this is a Bear rally or a true Bull run - or if the "recovery" will be a V - W - L - etc. but we can't ignore the rally.
I also believe there will be crazy signs that traders should not ignore before the next correction. I'm keeping an eye on commodities - if they really bubble (like oil did last year) then I'm selling down to 20 percent equities. I've got a plan in place to move cash to TIPS when inflation ramps up as well. My plan is to go with the market, cover, sell to cash if losses approach 10 percent. I should be selling into the rally, I know, but this rally is so unlike anything we've seen before.

Aug 08 09:11 PM

[derryl:]

I think it's pretty clear, as this article's title implies, that this is a hype rally that is not based on any kind of fundamentals like PE or PV or an improving economy but is a pure speculative play that is almost certainly being engineered by high frequency trading. So I think it's a mistake to try to apply normal economic analysis to this market. What we need to think about is, how long can the bubbleblowers keep up this success?

GS is now 'predicting' 3% growth in the 4th 1/4. JPM and Citi are likewise predicting rosy scenarios. There is a concerted effort to reflate the bubbles and so far it is working in the stock markets. Cash for clunkers boosted this 1/4's auto sales. $8000 towards price-slashed first homes boosts real estate. At the highest levels of government and finance everybody is working together to reflate.

Somebody commented yesterday that, "Nobody ever went broke taking profits." That is good advice. I bought Citi at $1.82 and $2.12 as soon as I knew it wasn't going to be nationalized and sold it less than a month later at over $4. At the same time I bought Dow at $8.70 and sold less than a month later at just under $17. Citi still flounders in the crapper but last I looked Dow was over $23. Big deal. I have the cash. I don't see that I 'lost' anything by getting in and out early. I bought some other good companies, for cheap, that I'm going to hold onto (all in energy).

I personally think this current uptrend can be extended for quite some time yet. Remember, it's all psychology, not economics. Equities are "hard assets", ownership of real companies, so fear of a declining dollar or inflation should make equities attractive to that psychology. But investors seem to have a superstitious fear of the dreaded "October", and I already see many predicting a pullback in October. That fear can be self-fulfilling in this kind of market. So it may not be a bad idea to take some profits between now and then, even if you leave some further upside on the table.

None of the bubble blowers dare to mention the real problem this rally might face, which is the effects of debt deflation on the real economy and on the solvency of the financial system. All the stimulus and hype is so far keeping deflation at bay, but for how long is anybody's guess.

There are no indicators of anything that might start generating major improvements in the real economy which might lead to some credit-fueled growth and hence some inflation. In fact all the indicators point towards more downside in the real economy and continued debt paydowns by anybody who can get their hands on some spare cash, and this is deflationary.

You won't lose anything by sitting out this imaginary rally, but you will not gain anything either. Remember, nobody makes any trading profits by buying stocks. You only make money when you sell them. So hang in there until it gets too scary then take your money and watch the fun.

Aug 08 10:20 PM

[Anthony Alfidi:]

Goldman blew a nice bubble in oil last year when they predicted it would go to $200/barrell. Their black boxes (Global alpha, etc.) made money by sucking investors into oil in 2008.

Aug 09 03:26 AM

[noob:]

What would happen if the Fed just let rates float according to their natural value instead of screwing with it?

Might help avoid some of these problems.

Of course, we could do better if we just removed the Fed completely


On Aug 07 01:32 PM Michael Clark wrote:

> I couldn't agree more. The Maestro (Greenspan) should have started
> raising rates in 2000 slowly, anticipating what 18 years of cheap
> credit would do. It's political suicide to raise rates unless we
> are swamped by inflation. The Fed is supposed to be independent
> so he can afford to make such decisions without being worried about
> the politics.

Aug 09 10:02 AM

[nmelendez:]

All i have to say is "the bigger the bubble, the bigger the....*POP*..."

Aug 09 05:35 PM

[nmelendez:]

BTW remember...stocks did not start to rise, in 2003/4 until interest rates started to go up...

Aug 09 05:37 PM

[FB5000:]

Oh I don't like Cap and Trade. I would much prefer a straight carbon tax AND a gasoline tax - probably about a $1/gallon. But Cap and Trade is not an unreasonable response - if they take the Corporate welfare out of it and remove the protectionist nonsense that those morons in the Congress have inserted in there.

Flame on lads - I am sure you will all hate this point of view.

But the fact is that there are externalities with fossil fuels and those externalities need to be paid for. If you don't understand what I am talking about - look up Coases Law. It is good stuff.

The gas tax is a demand management tool and candidly it needs to come in and soon. Again it is a much more direct and straightforward way to speed conversion. Don't subsidize entrepeneurs. Raising gas prices by a buck via tax will reduce demand, speed innovation and reduce oil and gasoline imports. It will hurt short term but long run there are gains plus it raises revenue and for all the folks who are worried about deficits it will help with that. Yes it will crimp economic activity - for a while - but there is no time like the now - while oil is again cheap - and you can always reduce income tax rates for the middle classes as a sort of give back. Yes it will be regressive but that's life.

While I am at it. Get rid of the mortgage deduction. Another massive distortion. Uncle Sam want's you to speculate in housing. Why? I own a house and have a mortgage - I like the free money but it is a distortion and has to go. If youwant a reason for th ehousing bubble look no further.

These policies - straight up would be very unpopular but would raise revenue - remove distortions and ultimately lead to improved efficiency.

Flame on lads. I am sure this one will be despised.

That's all.

On Aug 08 06:29 PM robert.b.ferguson wrote:

> Can you say Cap and Trade?

Aug 10 02:09 AM

[specguy:]

deepv,
we may be a little rusty on our math but the discount rate you refer to is not the prevailing, near zero rates in the environment but rather the wacc of the respective company under consideration. IOW, its the cost of capital which is the firm-specific risk.
Did you take finance 101?


On Aug 07 07:44 PM Deepv wrote:
Where is the bubble? dell on 10x earnings? China -- fine. Show me the bubble! I thin you all need to get a grip and learn stock = PV of future cashflows. Don't look now but the discount rate is awfully low. You guys took math right
> Where is the bubble? dell on 10x earnings? China -- fine. Show me
> the bubble! I thin you all need to get a grip and learn stock = PV
> of future cashflows. Don't look now but the discount rate is awfully
> low. You guys took math right?

Aug 10 03:40 AM

[Michael Clark:]

Bypho: actually these are not religious rants. They are descriptions of our shared economic reality from the perspective of the poetic, or symbolic mind.

I tells me something about you that you feel so threatened by them however.

And I am not a crackhead. And who made you the censor of this website? How long have you been hired by Seeking Alpha staff to decide what is appropriate here and what is not?




On Aug 08 11:50 AM BPYHO wrote:

> Hey crackhead, save your religious rants for somewhere else, it's
> not appropriate here.

Aug 10 07:00 AM

[Michael Clark:]

Excellent post.


On Aug 08 08:01 PM Fat Squirrel wrote:

> I've never understood some people's slavish and superficial reliance
> upon earnings multiples as an indicator of value. Under normal 'equilibrium'
> conditions, perhaps they offer some useful insight into relative
> value, but in a situation where company top lines are dependent upon
> government spending to an unprecedented degree, isn't the real question
> "how stable is stimulus-derived demand"? Or "what are threal e consequences
> of stimulus-induced demand shifting?"
>
> Several examples of this immediately spring to mind:
> 1) Bank earnings seem to be largely manufactured now through 'trading
> profits', newly-created accounting gimmicks, deferring the realization
> of loan losses many times capital, and back-door infusions of government
> (taxpayer) capital through above-market derivatives transactions
> (eg AIG -> GS, etc). To say, on the basis of current “earnings”
> and historic multiples, that financials are cheap seems to completely
> miss the point that the “earnings” to which these multiples are being
> applied are completely unsustainable and of exceptionally low quality.
>
> 2) The much-ballyhooed 'low multiples' of emerging markets seem to
> completely overlook the fact that the Chinese government's stimulus
> (and the consequential wave of private borrowing and demand front-running
> in commodities) has caused a similar artificial spike in earnings.
> To apply normal multiples to these puffed-up earnings seems like
> a fine way to overpay for stocks.
> 3) The Cash for Clunkers deal is another classic example of pulling
> forward future demand into the present. Yes, it makes the current
> period's numbers look great, but only at the expense of prolonged
> *depressed* future demand. What do we do after the sugar high has
> passed and we're stuck with protracted subpar sales in coming quarters?
> These programs do not create new demand, they just change its timing.
>
>
> The Green Shootists who love to extrapolate the stimulus-induced
> sales and earnings increases indefinitely into the future and to
> then cite these as evidence of a "recovery" are, at best, suffering
> from severe cases of confirmation bias. Crowd psychology and the
> expression of people's vested interests are also playing a significant
> role here.
>
> As earlier posters have pointed out, stocks are supposed to be priced
> at a risk-discounted present value (seekingalpha.com/symbo...)
> of future cash flows, but under the present circumstances we really
> need to consider just how stable current "sales", "earnings" and,
> by extension, cashflows are given the gargantuan distortions introduced
> by aggressive government interference in the economy.
>
> Also, a key determinant of PV is the discount rate applied to future
> earnings. The lower the discount rate, the higher the PV (and hence
> the higher the theoretical value of a stock with an assumed future
> earnings stream). But this is fraught with problems:
> 1) The usual way to select a discount rate is to take a “risk-free”
> rate (eg treasuries of a comparable term) and then to add a “suitable”
> risk premium. But Treasury rates are currently being manipulated
> down (seekingalpha.com/symbo...) and are at multi-decade
> lows. Is it really wise to use these artificially-lowered base rates
> when discounting future earnings to arrive at 'fair' stock prices?
>
> 2) Interest rates (and by extension discount rates) are also a function
> of inflation expectations. Given the apparent love affair of central
> banks around the world with historically unprecedented money printing,
> shouldn't we expect much higher inflation a few years hence? If
> so, then the discount rates we apply to longer term earnings streams
> need to be MUCH higher (would would greatly reduce the PV of future
> earnings and of theoretical stock prices).
>
> Sitting out a huge manic market spike is admittedly painful, and
> trying to time its end by going short is doubly so, but I'd urge
> people to really focus on the sustainability of the underlying forces
> driving the apparent improvements being used to justify the continuation
> of the current market mania both here and abroad.

Aug 10 07:06 AM

[Michael Clark:]

I don't think anything is 'natural' in man's manipulated financial systems. If we don't have the Fed manipulating rates, we'll have bankers and hedge fund managers attempting to do so. If there was no such thing as collusion, price-fixing, and corner markets, then we would not need the Fed. The problem with Greenspan/Bernanke was that he (aren't they the same man?) was a religious zealot masquerading as a man of reason.

In the ideal world, capitalism and competition drive down prices. In the global economy capitalism, prices never fall, prices are fixed at higher and higher levels, so that return on investment always climbs.


On Aug 09 10:02 AM noob wrote:

> What would happen if the Fed just let rates float according to their
> natural value instead of screwing with it?
>
> Might help avoid some of these problems.
>
> Of course, we could do better if we just removed the Fed completely
>

Aug 10 07:19 AM

[Avooch:]

Deepv,

buying great companies at good prices - who'd of thunk ?

I can only find one or two Enterprises to go long on these days. The rest are so wildly overpriced, that it boggles my mind.

What is your buy for, say, GE ? I have GE at $6 per common.

gudovac1941.blogspot.com/

----------------------...

Don't Get Massacred !


On Aug 07 03:47 PM Deepv wrote:

> you guys are always trying to call the market on seekingalpha. you
> guys should learn to invest in great companies at excellent prices
> instead of wasting so much time on silly macro. macro was awesome
> for about 18 months in the last 50 years. now it is back were it
> belongs, at the bottom of drawer. there is a reason why you don't
> know too many rich economist. macro is piss in wind stuff. go read
> a balance sheet.

Aug 10 07:44 AM

[Avooch:]

"...........Sitting out a huge manic market spike is admittedly painful, and trying to time its end by going short is doubly so, ..........."

well said -

I finally went long on a whole host of stocks late last year. After sitting out for a number of years, doing minor trades and focusing on emerging markets............a whole host of my price targets were hit for individual enterprises. I went extreme long beginning in October. Now I am stuck with monster gains and wondering if I should start selling. ..........

It takes just as much discipline to buy when others as selling as to sell when others are buying.

Aug 10 07:55 AM

[Paul Bogdanich:]

A very worrisome situation indeed. If the policy of reflation is abandoned it will be becausee the policy makers were forced, compeled, to abandon it. The only way that happens is if we can't borrow the money and the monetization of the debt breaks or threatens to break the currency. In that situation cash is of diminished use as well. Gold is good for squat besides giving you a warm feeling but you can't buy anything with it nor pay your bills with it. I personally don't see anything that's "safe" right now. So when in doubt follow the liquidity.

Aug 10 12:32 PM

[Paul Bogdanich:]

And it is the primary dealers that are fueling this rally. If the Fed allows the T bill/bond purchase program to lapse September 30, 2009, the primary dealers bail and the markets go South.


On Aug 08 01:12 PM bearfund wrote:

> Distribute by helicopter would actually be a lot less harmful than
> what we have today. At least you have some chance of standing where
> the helicopter happens to be. The current regime enriches traders
> employed by Primary Dealers and basically no one else.

Aug 10 12:38 PM

[Northstar10000:]

Whether you are a bull or bear everyone has said the good earnings are due to cost cutting. Top line growth isn't there. If top line growth does not show up this quarter it's going to be Katie Bar The Door.
Pre announcements will do, actual reports will be too late. There is no top line growth reported so far. It's early but the clock is ticking. Did I mention the Goldman Report! Oh ya, forget everything, just buy SDS at the open on Monday. It's already too late.

Aug 15 06:30 PM