On Bubbles and the Market Recovery

Bloomberg put up a headline Thursday morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says."

Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying, “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”

We are still learning about asset bubbles and credit bubbles, so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.

“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma said. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”

“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”

According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.

Rather than the funds going directly into the spending flow and increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.

How could this situation have evolved, having just gone through three recent experiences of asset or credit bubbles, including the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?

In this respect, another person, Arthur Smithers, who has a “deep understanding of economics and a lifetime’s experience of financial markets,” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times) has also questioned current values in stock markets.

Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin, and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance.”)

Both measures related to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.

According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.

Why would the value of the stock market deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha.)

Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.

Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”

This is exactly the problem that I presented in my posts of October 26, and October 27. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.

Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But these problems are for another time, and the politicians don’t have to focus on them yet.

Comments

[Michael Clark:]

The market bubble IS ending. See charts below.

seekingalpha.com/insta...

Oct 29 12:53 PM

[Whoa Nelly:]

The bubbles are coming faster and faster and perhaps bigger and bigger because "they" are running out of ways to keep kicking the can down the road, to keep pulling demand further from the future, to keep the great darkness ahead from arriving.

Each bubble has to be bigger and faster than the last to prevent the pain from the previous pop.

It's really no different than a heroin addict that starts out with a hit or two a day but is left with needing a hit every few hours right up until his heart explodes.

The economic heart is beating faster and hrader and is about to explode.

Oct 29 01:48 PM

[bob adamson:]

The paradox is that bubbles created the background against which the meltdown of last year occurred, modest reflating or at least substituting for losses in those bubbles was necessary to manage the crisis of the meltdown and prevention of disorderly future collapse of those bubbles is necessary to forestall a renewed meltdown. A further paradox is the need to ultimately resolve these bubbles and prevent new ones from arising is paramount if the US and global economies are to be put on a sound basis.

These will be many stages of the work over a long time needed to resolve these paradoxes productively; there is no one-time dramatic fix.

Oct 29 02:00 PM

[Mad Hedge F...:]

uute Those of you who heeded my GLOBAL RISK ALERT on October 13(click here for report at www.madhedgefundtrader...) missed the top of the market by six trading days and 10 S&P points. I’m sorry; I’ll ring the bell more precisely next time, with a more accurate date and time. Since then, technical sell recommendations have been breaking out like acne at a junior year prom dance. You are all now out of your positions or love them so much that you are willing to carry them through another crash. At the risk of hubris, even PIMCO’s Bill Gross has jumped on the bandwagon, although I doubt he needs my help ascertaining the direction of stocks and bonds. The way everything turned tail and ran at exactly the same time was a complete vindication of my theory that a tsunami of liquidity was raising all boats, completely unjustified by the underlying fundamentals. Long time readers of this letter know the only short I have advocated this year was in long dated Treasury bonds through the TBT. But the better than expected Q3 GDP of 3.5%, obviously fueled by temporary government programs like “cash for clunkers” and the first time homebuyers tax credit, may be presenting one of those pristine, “sell on the news” moments. Will this data finally give us our long awaited double top? Fading rallies in stocks is looking more enticing by the day.

Oct 29 02:13 PM

[User 344476:]

I would be interested in an article that explains just how "Liquidity has found its way to the wrong assets." What are the mechanisms? If the banks have the money, but are not lending it out, where do the dollars go and how do they get there? Are banks buying stocks?

It stands to reason then, if money that is normally loaned is flowing into stocks instead, that money will have to come out of stocks in order to be loaned. Doesn't that foreshadow a market drop when conditions improve? If so, could it happen just when the general public sees the economy improving and begins getting back into the market? Could it cause a crisis of trust?

Oct 29 08:37 PM

[Dean M:]

Interesting how all these heavyweights are coordinating their efforts to jawbone the market down all of a sudden. Maybe they are trying to cover up their own meager performance by year end.

Oct 30 12:04 AM

[artkarl:]

In other words, we're always fighting the previous war.
-Karl Krachenberg

Oct 30 04:21 PM