Beware the Next Bubble

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Includes: DIA, SPY
by: Shishir Nigam

The earliest known bubble was the “Dutch tulip mania” in 1637 which resulted in tulips contracts being sold for more than 10 times the annual income of a skilled craftsman (according to Wikipedia). And of course, shortly thereafter, the price of tulips crashed back to normal “flower levels”. All bubbles since have shared one thing in common – large groups of people thinking irrationally, all at the same time.

The clean-up act

Alan Greenspan has maintained that the government’s focus should be to reduce the effects resulting from a bursting bubble, as opposed to discouraging its development in the first place. When the tech bubble burst, the Fed reduced interest rates to 1% for an extended period of time and this is what many believe to have caused the next bubble.

With interest lost in the stock market, the cheap money went into the housing market and housing prices across the US and many other countries started inflating. Robert Shiller has done some fascinating research on this topic in his book “Irrational Exuberance” which supports this point of view. Housing prices continued to rise throughout the decade up till 2006 at which time housing starts (indicative of the supply of new homes) in the US peaked at roughly 2.3 million and have since fallen to a low of 488,000 in Jan, 2009. The domino effects of the collapsing housing market are now clear for everyone to see.

However, the policy response chosen by Ben Bernanke is hardly discernable from that of Alan Greenspan a decade ago, except in its magnitude. Interest rates are now at 0.25% and the Fed has done enough “quantitative easing” to result in the biggest expansion of money supply in history. And the steps of the Fed have been emulated by central banks all around the world. I question why policy makers are inclined to focus on reactive policies which address the fallout from a crisis as opposed to focusing on proactive policy making, addressing the factors that cause bubbles in the first place. Is that not a better long term solution?

Riding the bubble, reluctantly

Lou Jiwei, the chairman of China’s $298 billion strong China Investment Corp, said recently that, “Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”

Indications show that the money which central banks are pumping into economies is flowing straight into the stock markets. Global equities have been risen 50-60% with hardly a hiccup and if the markets are accurate, then they are pricing in a perfect V-shaped recovery without any chinks. However, reality and fundamentals disagree. Companies have not reported any revenue growth, unemployment has yet to peak and industrial production has been stumbling. Such a disconnect points to signs of irrationality characteristic of Bubble-ville.

Should investors have nothing to do with the exuberant market because they disagree with the fundamental reasons behind it? The biggest challenge is to profit from a bubble while consciously knowing that it is one and pulling out before the proverbial pin pricks it. Unfortunately, by definition, a bubble pulls in many un-informed investors who cannot resist the rising prices and have no recognition of a bubble’s existence.

Are we trying to avoid becoming like Bubble-ville through our policies but in our efforts to do so, inadvertently becoming more and more like it? Or is our society and capitalism as a whole simply incapable of surviving without the existence of bubbles? Regardless of the answers to those questions, we are in for a rocky ride thanks to a few people who seem to be making all the decisions for us. So the next time you hear a POP, don’t be alarmed! It’s probably just another bubble bursting after hyper-ventilating on self-generated fumes of optimism, greed and euphoria.

POP!

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