What's Behind the Coming Market Crash?

Only a few weeks ago, markets around the world were hitting record highs, day after day. After two queasy weeks in the markets, the mood has quickly turned somber. Scan the strategy pieces of investment banks, and a coming market crash has become conventional wisdom virtually overnight. Morgan Stanley has predicted a "14% correction over the next six months." Rival banks place the odds of a market crash before the end of the year at one in four. Union Bancaire Privée, Switzerland's private banking giant, called all financial assets simply "jaded" -- recommending cash and commodities. Only Ravi Bahta -- (in)famous author of the "The Great Depression of 1990" -- appears unnervingly optimistic. He recently published a new book entitled: "The New Golden Age."

The Coming Market Crash: Today's Bubbles

Markets crash when financial bubbles burst. Certainly, today's financial market has its share of bubble candidates. Famous "Gloom, Boom and Doom" monger Marc Faber noted in the Financial Times last week that the only global asset that isn't in a bubble is the U.S. dollar. That being said, here are my own top three bubble candidates.

Bubble # 1: Global Property

Although the air is being let out of the property bubble in markets as diverse as Florida and Spain, the global property boom trundles on. Big bonuses on Wall Street and London, recycled petrodollars from the Middle East and Russia, combined with looser lending standards for the Average Joe, have driven property prices up across the globe. Property in central London is reaching dotcom era levels of absurdity. A two-bedroom flat in Mayfair -- a tony part of London -- last week went on the market for $3 million. After attracting 14 bidders, it was sold for close to $5.4 million -- 85% above its asking price. To get a 6% gross yield, it would have to rent for $27,000 per month.

Bubble # 2: Private Equity Boom

Private equity today suffers from the familiar and often fatal symptoms of a financial bubble: "too much money chasing too few goods." Companies that were valued at PEs of 12, are now being sold for 20 to 30 times earnings. The fuel for this particular financial fire is low interest rates. For the first time ever, some banks are lending out money below base rates. And they're doing this with "cov-lite" ("covenant lite") terms that give little legal recourse when things go awry. Justified by plenty of "this time it's different" thinking, banks' looser lending standards may be planting the seeds of their own demise.

Bubble # 3: "Chindia"

Scan any business bookshelf in your local bookstore, and you'll be struck by the number of books with the word "China" in the title. Financial newsletters touting Chinese stocks are the top-selling newsletters around. Books on India are slightly harder to come by -- hence the new term "Chindia," which binds the economic juggernauts together in one convenient slogan. The apparent inevitability of Chindia's domination in the 21st century mirrors predictions about Japan 20 years ago. Another worrisome sign of the Chindia bubble? Time magazine featured both India and China in cover stories over the past six months -- a terrific contrary indicator.

The Coming Market Crash: The Causes

The reason for the coming crash will be clear as day -- with the benefit of 20/20 hindsight.

Today, that reason is still murky. But here are some guesses.

Cause #1: A Sharp U.S. Slowdown

Conventional wisdom has it that the United States has successfully weathered the worst of the recent economic slowdown. Yet a handful of economists predict that the combination of skyrocketing debt as a percentage of GDP, the slowest corporate earnings growth since 2002, and the collapse in the housing market will cause the global economy to fall out of bed. Although European commentators revel in their observation that the U.S. economy isn't quite the big kid on the global economic block it once was, it's still the case that when the United States sneezes, the world catches a cold.

Cause # 2: Rising Interest Rates

Change the interest rate assumptions behind all those spreadsheet models that justify the investments by private equity firms, and the private equity financial locomotive can quickly become derailed. Ditto for commercial real-estate deals. Every financial mania also has its iconic transaction that portends its collapse. Remember Jerry Levin and Steve Case shaking hands in the AOL-Time Warner (TWX) deal? Blackstone's (BX) IPO last week -- and Steve Schwarzman's $9 billion fortune -- just may turn out to be that transaction in the private equity era.

Cause #3: The End of the China Mania

When the China market crashes, it will be the most telegraphed crash in history. Ironically, the Arab markets -- which, like Shanghai are off limits to global investors -- crashed just 18 months ago. No one noticed. But like the Middle Eastern markets last year, China's market collapse is not a question of if, but when. No market in the world -- including the United States in the 19th century -- emerged as a global economic power without massive booms and busts in financial markets. To claim China will be different is simply ingenuous. The only real question is whether global markets will have the stamina to shrug China's collapse off -- or will China drag Western markets down with it.

The Coming Market Crash: What Is to Be Done?

Analysis is easy. Taking action is hard. Getting the timing right is almost impossible. I know several London property owners who exited the market two years ago. Today, they are living in rented accommodations -- and are farther than ever from getting back on the property ladder. They claim they weren't wrong -- just early. Time will tell.

The almost uncontrolled growth of credit, trade and derivative flows makes this both a heady and uncertain time in global financial markets. As one commentator pointed out, anyone who says he has found an answer has not done his analysis.

But all this hand-wringing is perhaps the best news of all. Financial manias peak when the future is clear blue skies as far as the eye can see. Financial headlines about a coming crash may themselves be a contrary indicator. The mere talk of a crash provides a "wall of worry" for the markets to climb.

Comments

[Sr. Pessimist:]

Cause #4: Underpaid Workers Have Had Enough

Labor exploitation won't go over well anymore. Engineers hate their corporations, and corporations treat their engineers like they're disposable human resource. No loyalty either way. Engineers calculate how sick they are of working to cover the bureaucratic costs of making their working lives hell.

2007 Jul 03 09:19 AM

[atauber:]

as CHINA is creating new wage earners every day there is no risk of a crash

2007 Jul 03 09:37 AM

[kkin365:]

Sooner or later, everyone dies. So what is new? What is new in the "analysis" given above, particularly with reference to China? omooc

2007 Jul 03 09:48 AM

[kkin365:]

Sooner or later, everyone dies. So what is new? What is new in the "analysis" given above, particularly with reference to China? omooc

2007 Jul 03 09:48 AM

[kkin365:]

Sooner or later, everyone dies. So what is new? What is new in the "analysis" given above, particularly with reference to China? omooc

2007 Jul 03 09:49 AM

[wixeywaxy:]

The price of earnings is probably a bit on the high side but whither we have a correction that will last more than a few months is totally dependent on the profit outlook so that's what we need to focus on. The people who pretend to know what direction the stock market is going to take are really making an economic forecast. Given that I don't think it's all that clear that the economic condition is all that bad and I think the real estate problem is already factored into the equation and in many areas of the country is already improving. I can see that in my own neighborhood. Existing houses are selling and there are lookers that we weren't seeing a few months ago. Probably the summer will give us the stock market dulldrums but I will take it as a profit opportunity. Vic.

2007 Jul 03 10:12 AM

[benesposito:]

What if all the people not investing in the market (i.e. media) are talking about a crash, while the people still making money in the market are all saying "Everyone talking about a crash makes that a contrarian indicator". If all the want-to-be bulls are calling that a contrarian indicator, maybe that means they are all wrong this time.

2007 Jul 03 10:37 AM

[Sr. Pessimist:]

That's probably the best gauge available. I remember how the realty associations were predicting things were going to continue to get better up through past the start of the subprime mortgage meltdown. There's a lot of free money flying around. That's hard to pass up making a statement for.

I'm a worker. I don't care if I have a pile in the bank and a pile available in credit. I don't care if I make a million dollars this month or a billion in a few months. I don't care if we give up dollars for seashells as a currency. I don't care if we can turn iron into gold and resort to trading oil commodity certificates to sustain currency-driven trade. Money is stupid to me. Work is valuable. I'm intelligent enough to see the forest for the trees. I'll work just to feel good about the work I did. I'll work to feel valuable.

The market of idiots who claim that they own the work of laborers can wither and perish. I don't care if the born-rich are doing poorly and they'd rather the entire country starve to death in a depression than give up their carefree lives. I don't care how much debt the US Government decides it wants to go in, hoping that the upcoming labor force is weakling enough to hang around and pay it off 'cuz we're s'bosed to.

My software work is valuable, even if the evil US Dollar is not. Plus, I doubly agree with the bubble #2 point in private equity. Too few valuable producers, too much currency chasing it to capture the wealth produced. The capitalist market cannot savagely attack like it has anymore. There are just too few good producers. I've been downright harassed my whole life just because I'm intelligent and a good worker. It now merely serves as a reminder that I'm a valuable worker.

The American dream is not to work, get better, prove your ability, expand your skills, and then work more and get better more. The American dream is to make everybody else do it for you while you do nothing and get all the stuff they made for yourself. That doesn't fly when there are too few "everybody else"s to "do it for you." Those "everybody else"s become the minority eventually. So let's take another look at bubble #2 and then compare American laborers and education standards to those of the international community. Right now, software and engineering are must-haves. We have very little talent in either. There are perhaps only a dozen aerospace engineers in the United States that can do a fluid system analysis right. And there is probably just one software engineer in the United States who has the talent to put large-scale commercialized video on mobile phones in a vastly economically feasible manner all on his own.

2007 Jul 03 01:27 PM

[altthoughts:]

and that would be you, right?

2007 Jul 03 10:56 PM

[NutritionFacts:]

Yawn.

2007 Jul 07 06:59 PM

[Sonia Mirza:]

Market crash - is that what they're calling it these days?

The fact that it's in the news means it's too late - the media is often the last one to verbalize/admit/relay any downturn - let alone this 'mkt crash'. If we all know it's a market crash - why hasn't it happened already? If we all believed it was, we would all simultaneously act accordingly and cause it to occur NOW...

Crash - I think not. Correction - perhaps.

2007 Jul 08 11:31 AM

[bmoreluv:]

I'd like to know how you guys think about the following concerns: Besides the obvious labor issues, don't you guys get the connection between the 'health' of the stock market and the illness of our worldwide ecosystems? Do you consider this a trivial matter?

2007 Aug 13 01:49 AM

[Randy Kirk:]

There are some significant differences between China currently and the US during the 19th century. A chapter in Marc Faber's book "Tomorrow's Gold: Asia's Age of Discovery" concerned investment performance in the United States in the 19th Century -- one could compare the US in the 1800's with China in the later part of the 20th and the 21st Centuries -- noting that European investors, for the most part, were burned in investments in the US. The analogy is that foreign investors could be burned in China as the economy goes through booms and busts like the US in the 1800's -- however there are significant differences between China currently and the US in the 19th century:
1. Central bank differences -- the US abolished the Fed under Pres. Andrew Jackson and for the majority of the 19th century, so lacked interest rate, money supply and a "guaranteer of last resort" -- China has a very vigilant Central Bank currently (which incidentally continues to forecast very high rates of growth and maintains that the Chinese economy is very strong) see:www.pbc.gov.cn/english/
2. Investment laws -- there was no SEC until the 1930's, China currently has a Securities Regulation Commission and has publicly stated that it views investment into China as a very high priority. Fraud is at least somewhat mitigated in China verses unsupervised in the US in the 1800's.
3. The Chinese government views economic growth as a matter of life and death -- as there is over a 100 million "floating" population which could become a huge potential problem without employment. Further, with $1.3trillion of reserves and increasing daily, the Chinese government has room to maneuver to support the economy
4. Domestic structure of the Chinese economy is different -- the US in the 1800's was more "laissez faire" in terms of governmental intervention and regulation, while the Chinese government plays a larger role in its domestic economy currently than the US did in the 19th century
5. Different international situation - China is playing "catch up" with the rest of the world in terms of GDP per capita, while, at the middle to end of the 19th century, the US was one of the richest countries in the world, with gdp per capita almost 4x the level of Italy in 1900. Technology can flow more easily into China than the US in the 1800's, due to technology and also the fact that China can borrow ideas from abroad, while the US was or was very close to the world's technological leader during the 1800's.

2007 Dec 27 04:18 PM

[Randy Kirk:]

One more thing -- the Middle Eastern stock markets, on the whole, have not "crashed" -- it depends on the market. In fact many of them are at or near their highs and of the ones that have crashed, they currently (late 12/07) are in uptrends, well off their lows. The Kuwait stock market has gone from a level of less than 3000 in 2004 to 12447 currently (12/07), which slightly off its high of 13000. The Bahrain stock market is currently at an all time high of 2716 (up from 2200 in 2005). The Saudi Market has fallen, from a high of 20,000 in early 2006 but is now in an uptrend to 12,400 currently (from bottoming out at 7000 in 2007 -- very volatile). The Dubai stock exchange is somewhat off its high of 8,000 in late 2005 to 6,000 currently. But both Saudi and Dubai are in uptrends currently. See all long term charts here: www.asmainfo.com/chart...

2007 Dec 27 04:38 PM