Wednesday, April 25, 2007
April 24, 2007
It’s Everywhere, In Everything: The First Truly Global Bubble
(Observations following a 6-week Round-the-World Trip)
From Indian antiquities to modern Chinese art; from land
in Panama to Mayfair; from forestry, infrastructure, and the
junkiest bonds to mundane blue chips; it’s bubble time!
The necessary conditions for a bubble to form are quite
simple and number only two. First, the fundamental
economic conditions must look at least excellent – and
near perfect is better. Second, liquidity must be generous
in quantity and price: it must be easy and cheap to
leverage. If these two conditions have ever been present
without causing a bubble it has escaped our attention.
Conversely, only one of the conditions without the other
may cause an ordinary bull market but this is often not the
case. For example, good or even excellent fundamentals
with tightening credit often result in a falling market.
That these two conditions have been met now hardly needs
statistical support, so widely accepted have they become.
Never before have all emerging countries outperformed
the U.S. in GDP growth over a 12-month period until
now, and this when the U.S. has been doing well. Not
a single country anywhere – emerging or developed –
out of 42 listed by The Economist grew its GDP by less
than Switzerland’s 2.2%! Amazingly uniform strength,
and yet another sign of how globalized and correlated
fundamentals have become, as well as the fi nancial
markets that refl ect them.
Bubbles, of course, are based on human behavior, and
the mechanism is surprisingly simple: perfect conditions
create very strong “animal spirits,” refl ected statistically
in a low risk premium. Widely available cheap credit
offers investors the opportunity to act on their optimism.
Sustained strong fundamentals and sustained easy credit
go one better; they allow for continued reinforcement:
the more leverage you take, the better you do; the better
you do, the more leverage you take.
A critical part of a bubble is the reinforcement you get for
your very optimistic view from those around you. And
of course, as often mentioned, this is helped along by the
fi nance industry, broadly defi ned, that makes more money
when optimism and activity are high. Hence they have
every incentive to support rising markets as they do. But
geography and culture can weaken the chain. The South
Sea bubble was infl uenced by earlier speculation in France,
but was distant and alien to the rest of the world. The great
Japanese land and stock bubble was utterly persuasive to
everyone in Japan, but completely unpersuasive to almost
all of our clients. Seen through our eyes 10,000 miles
away, it seemed obviously overdone and dangerous, didn’t
it? Even the 2000 bubble was really confi ned to TMT in
the developed countries.
But this time, everyone, everywhere is reinforcing one
another. Wherever you travel you will hear it confi rmed
that “they don’t make any more land,” and that “with these
growth rates and low interest rates, equity markets must
keep rising,” and “private equity will continue to drive
the markets.” To say the least, there has never ever been
anything like the uniformity of this reinforcement.
The results seem quite predictable and consistent. All
three major asset classes – real estate, stocks, and bonds –
measure expensive compared with their histories
and compared with replacement cost where it can be
calculated. The risk premium has reached a historic low
everywhere: last quarter we showed that by using our
7-year forecasts to create effi cient portfolios for high,
medium, and low risk levels, the return for taking risk had
dropped precipitously from September 2002 until May of
last year. To be precise, the gap between our low and
high risk portfolios on our 7-year forecast in September
2002 was 6.4% points and by May last year it was a paltry
0.8%. But in Australia last month it was pointed out that
we had missed the point, that all these portfolios included
our expected alpha, which not surprisingly is higher for the
risky portfolios (small cap and emerging) than it is for low
risk portfolios (cash and TIPS). So Exhibit 1 reproduces
the three points in time, using just the asset class forecast.
As of May last year we now show – drum roll – the fi rst
negative sloping risk return line we have ever seen. Just
think about it: if we are correct, the process of moving
all asset prices smoothly to fair value over 7 years (which
is how we do our 7-year forecasts) will have resulted
in a world where investors are paying for the privilege
of taking risk! If you believed this data you should, of
course, put all your money in cash. In the real world,
unfortunately, even if you believed it with every fi ber in
your body, you could only have a little cash on the margin
because the career risk or business risk of moving more
would be unsupportable.
So to recap and extend:
1. Global fundamental economic conditions are nearly
perfect and have been for some time.
2. Availability of global credit is generous and cheap and
has been for some time.
3. Animal spirits and optimism are therefore high and
feed on themselves through reinforcing results and
through being universally shared.
4. All global assets refl ect this and are overpriced and
show, probably for the fi rst time, a negative return to
5. The correlation in global economic fundamentals
is at a new high, refl ected in the steadily increasing
correlation in asset price movements.
6. Global credit is more extended and more complicated
than ever before so that no one is sure where all the
increased risk has ended up.
7. Every bubble has always burst.
8. The bursting of the bubble will be across all countries
and all assets, with the probable exception of high
grade bonds. Risk premiums in particular will widen.
Since no similar global event has occurred before,
the stresses to the system are likely to be unexpected.
All of this is likely to depress confi dence and lower
9. Naturally the Fed and Fed equivalents overseas will
move to contain the economic damage as the Fed did
last time after the 2000 break. But the heart of the
last bubble, the NASDAQ and internet stocks, still
declined by almost 80% and 90%, respectively. (The
heart of the bubble this time is probably private equity.
In 10 years, it may well be described as the private
equity bubble just as 2000 is thought of as the internet
bubble. You heard it here fi rst!)
10. What is wrong with this logic? Something I hope.
11. Of course the tricky bit, as always, is timing. Most
bubbles, like internet stocks and Japanese land, go
through an exponential phase before breaking, usually
short in time but dramatic in extent. My colleagues
suggest that this global bubble has not yet had this phase
and perhaps they are right. (A surge in money fl owing
into private equity might cause just such a hyperbolic
phase.) In which case, pessimists or conservatives
will take considerably more pain. Again?!
This Time It’s Different
Yes, each bull market refl ects its near perfection in a
different way, with most accompanied by claims of a
golden new era. Today the apparently infi nite and cheap
supply of Chinese labor, a truly colossal U.S. trade defi cit,
and the sheer uniformity of easy money and strong
economics certainly give this one plenty of differences.
But under the surface capitalism eventually grinds pretty
fi ne. The return to capital and the cost of capital sooner
or later get into line. Competition bids down returns.
Confi dence to spend capital fi nally recovers. Profi t
margins, at long last, become normal or even drop below
normal. The workings of competitive capitalism are, in
the end, an irresistible force and that is why everything
always trends to normal and every very different bubble
has always burst. And hey, if it happened in a smooth and
regular way, how boring our business would be.
What Is the Catalyst for a Break?
Everywhere I went on my trip this was the question that
followed my gloomy talk. But there usually is no catalyst
that can be observed. We haven’t agreed yet on a catalyst
for 1929, 1987, or 2000, or even the South Sea bubble
for that matter. On pondering the reason for the lack of a
catalyst I offer a thought experiment (or tortured analogy).
A market in equilibrium can be likened to a ping-pong
ball sitting on a pool of water. You may have seen the
fun fair trick of having ping-pong balls sitting atop jets
of water that rise and fall with the power of the jets. The
force of the jet can be likened to economic and fi nancial
conditions. The more nearly perfect the fundamentals
and the more generous the liquidity, the higher the water
jet raises the ball. At maximum force the ball is as high as
it gets – a bull market peak. Then the jet is turned down a
little, so it still represents a nearly perfect set of conditions
but just the very slightest bit less perfect than it was – the
jet is slightly lower and the ball falls. If bear markets start
in nearly perfect conditions, far above average but just a
little worse than the day before, what chance do historians
have of fi nding the trigger? It is lost in a second derivative
nuance. And, by the time conditions are merely well above
average, the most leveraged and aggressive investors
have registered the series of declines and are beginning
to take evasive action. From here intelligent career and
business risk management creates the normal herding or
momentum, but in a seamless way as slight reductions
in real conditions blend in with gamesmanship. Given
all the uncertainties and the fact that conditions do not
weaken linearly but in uneven and unpredictable steps, is
it any surprise that we always miss market tops?
Having said all this, what are the special vulnerabilities
this time that might work over a period of time to reduce
the near perfection of today’s market conditions? The fi rst
is easy: rising infl ation. It constrains the Fed’s support to
any weakening economy, and the U.S. economy is indeed
weakening. It directly lowers the traditional bond markets.
Stocks may be real assets, but behaviorally it destabilizes
stock investors and causes P/Es to fall. In the short term
it tends to depress profi t margins as corporations relearn
how to pass through any cost increases. It wreaks havoc
with housing and commercial real estate by lowering the
possible leverage and therefore lowering prices. And
perhaps most signifi cantly this cycle, it lowers the feasible
leverage in private equity deals and places many deals
that can be done today out of reach, which in turn has dire
effects on the current stock market.
The second possible catalyst is our old friend: profi t margins.
They are currently far above average globally and they
will, of course, come down. A slowing U.S. economy and
fewer pleasant global surprises will put pressure on profi t
margins. Possibly continued house price declines will slow
the growth of credit, and consumption will grow less fast.
There are leads and lags, and large retroactive changes to
the profi t margin data, so this factor is not so certain a death
knell to the bubble as is infl ation, but a couple of years of
margin declines should do the job just fi ne.
In late February we had a spot of trouble in the subprime
market. (“Subprime …” – it already begins to sound
familiar. Haven’t we always talked about it?) And a
Chinese red herring arbitrarily jumped in with a 9%
market decline in one day, for no related reason. The
combined effect was to create an echo of last May, where
the carry trade pulls back for a few days and lets us see
where the vulnerabilities are. There is a tendency to
say, “Whoopee! We always bounce back! We’re armor
plated!” This seems like a bad idea. There is probably lots
of information in these minor shocks, which may prove
useful for a major shock. Last May’s lesson, I believe,
was not that emerging markets could bounce back, but that
they could decline by 25% in three weeks in the face of
the best year fundamentally in emerging’s entire history.
What might the decline have been on bad news? A 50%
decline in 3 weeks? It just let us know the potential pain
in really bad risk-liquidity events. I suggest taking a close
look at one’s entire portfolio on each of these shocks and
checking for leaks in the boat – unexpected effects.
In May of last year emerging was a big holding for us,
but there was no real concern because we believed that
in an extended decline the extra value in emerging would
materialize as it did in 2002. And if the market recovered,
emerging would storm back. This time we took unexpected
pain in our fi xed income investments, which in many of
our asset allocation accounts had risen to 50%. We knew
that in general our fi xed income portfolios tend to prosper
as risk premiums narrow, whereas our equity accounts
have a hard time, and vice versa. It was just a question of
degree. In asset allocation, in our desire to have more of
fi xed income’s enviable alpha, we had probably reached for
a bit too much of it to be compatible with the normal risk
avoiding preference of our asset allocation portfolios. On
examination it really came down to having accumulated,
in the different portfolios, too much currency exposure,
which in turn can get in the way of carry trade events. So
after long consideration of alternatives, we reduced the
currency alpha exposure. It may be an over-reaction, and
you can never know for certain at the time (and indeed
risk taking in general continued to prosper in the fi rst
quarter), but I don’t think so.
I urge our clients to take a detailed look at all their
portfolios’ responses to these two jolts, for sometime
sooner or later the shots will not be across the bows.
-reprinted with permission.