Tuesday, December 8, 2009

How to Spot a Bubble

Bert Whitehead, M.B.A., J.D.

If you are younger than 40, you will likely be telling your kids and grandkids about the ‘Great Recession’ of 2007-2009. Our recent experience is likely to impact your investment decisions for the rest of your life. So what advice will you give the next couple of generations?

I’d suggest you start with: “Beware of Bubbles!” Hindsight is a huge advantage in recognizing dangerous financial bubbles. We are all familiar with the stock market crash which kicked off the ‘Great Depression.’ If you are over 40, you probably remember your elders caution to ‘Stay out of the Stock Market!’ That was the wrong lesson; the real lesson is to be wary of leverage. The stock market then was a huge bubble, aggravated by the ability of even small investors to leverage stock purchases on margin requiring an investment of only 5%.

Surely over-leveraged investments, spurred by easy credit is a hallmark of bubbles. In the 1970’s however, bond investors lost their shirts and inflation ravaged the stock market. It’s not so clear that leverage aggravated that recession as much as excessive government spending, high oil prices, and built-in cost-of-living increases which contributed to spiraling inflation. But when the fed raised interest rates, the reduced leverage eventually sucked the air out of the economy and resulted in new federal reorganization of the banking system. The S&L collapse soon followed.

The ‘Dot.Com’ bubble in the 90’s was fueled by an astounding amount of capital chasing new ideas. Tech stocks soared to incredible heights and seemed to be invulnerable to fundamental requirements. They had no P/E ratio because they could sell stocks without a revenue, much less profit. Those entrepreneurs failed miserably at being able to leverage the capital effectively.

In our current situation, there’s no question that easy money accessed by low mortgage rates and virtually no vetting of borrowers artificially inflated housing prices, and the financial industry tanked taking down the rest of the economy. It’s by no means certain that the government spending intended to create employment will solve the problem, and there is a real danger that excessive government debt will create worse problems down the road.

Looking at our present worldwide condition, there are at least three possible bubbles on the horizon: China, Gold, and most recently the financial disruption in Dubai and other closely allied emirates in the U.A.E.
The red flags in all three situations are all related to the same phenomenon: unsustainable rapid increase in expansion.

China, and many other emerging nations, have experienced a growth in production capability which carries the danger eventually of excess capacity. Hundreds of millions of Chinese moved to the cities for employment. Now they are without jobs because there simply isn’t enough worldwide demand to keep the factories operating. In the process China basically subsidized exports by keeping its currency, the Yuan, pegged artificially low to the dollar.

This enabled them to keep prices of exports low, so US purchasing essentially provided the capital for Chinese expansion in their private sector. The anomaly is that that the US has begun using Chinese lending power to fuel its public sector. This is ripe to start unraveling with unforeseen consequences, but the fallout will surely hurt investors who have rushed in to make a quick buck in China.

Gold is now at record highs. Since 2000 the price of gold has jumped from $252 to $1,100 per oz. and has been touted as the best antidote for inflation which has increased about 18% during that period. But it hasn’t fared so well in the past: the price of gold dropped the beginning of the 1980’s through the 1990’s (from $934 to $252 per ounce) while inflation surged 50%. Since there hasn’t been an increase in demand for production, the recent price increase is likely due to speculation. Gold ETF’s became available, which buy actual gold to hold for investors. So instead of having to buy gold, have it shipped, and then store it, speculators can buy and sell positions in one day’s trading. Bubbles that are created by speculative demand are very likely to collapse, even faster than their rise.

Recent news that Dubai is defaulting on $80 billion in debt has spooked the worldwide markets and undermined the assurance that Oil Sheiks would step in to back any debt. The massive construction in Dubai, which dwarfed the construction bubble in Las Vegas, was based on a conviction that ‘if you build it, they will come.’ Well it turns out that they’re not coming. There is no financial underpinning for a new city built in a desert without any existing industry or commercial basis.

What China, Gold, and Dubai have in common is that they experienced such spectacular growth that financial realities were increasingly ignored. A naïveté around basic economics inexplicably overtake even seasoned investors, then speculators start rushing to cash in the new hot investment, and finally the small investors pile on. Bubbles are built on an irrational belief that ‘this time it’s different’ and the balloon will never burst.

We have learned a valuable lesson, and bubbles will continue to form regardless of government regulation and our supposed increased financial sophistication. Our experience should be passed on. So be sure to lecture your children and grandchildren to “Beware of Bubbles!”

I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.