Sunday, April 24, 2005

Possible market bubbles abound



Could it be U.S. housing, commodities, China's economy?


Special to The Morning Call

With the benefit of hindsight, reasonable people today agree that technology stocks in the late 1990s became a monumental financial bubble.

Five years from now, what will the reasonable people of 2010 recall as the great bubble of 2005?

Or will they have trouble picking just one?

The housing market has become the most discussed candidate for bubble-hood this year. But unlike in 2000, when the dot-com mania had no market peers, housing today has some stiff competition on the financial gasp-o-meter.

The commodities market, led by oil, has had many of the earmarks of a bubble — not least a near-vertical ascent in prices until recently.

The booming Chinese economy has been slapped with the bubble label. The record U.S. trade deficit, partly an effect of China's boom, also looks bubbly in the sense that economists say it can't keep growing, yet it does.

Some Wall Street veterans say the global bond and mortgage markets may constitute the scariest bubble of all, as investors and lenders have fallen over themselves to extend credit to companies and individuals at generously low rates of interest. The creditors may come to regret their largess if the economy slows and many borrowers suddenly can't pay their bills.

Given that each of the aforementioned bubble candidates can be linked to one another with less effort than a game of Six Degrees of Kevin Bacon, it might be reasonable to suppose that they aren't individual bubbles but rather one mega-bubble — the totality of the economic and financial world we live in.

It isn't a pretty thought, of course, because the common denominator of all financial bubbles is that they create huge messes when they burst.

Recall the hundreds of billions of dollars in retirement savings lost by hardworking people when the technology bubble exploded during 2000-02. Then imagine the potential financial harm if, simultaneously, housing values went the way of tech stocks, China halted its massive buying of U.S. Treasury bonds (which has helped finance our budget deficit and kept U.S. interest rates down) and corporate lenders found that too many of their debtors really didn't deserve credit, or at least not on such benevolent terms.

The concept of a mega-bubble and its collapse is an accommodatingly depressing scenario for people who pine for the end of the world. It also may be a fiction borne of peoples' natural tendency to relate the present to the recent past, and assume that history must repeat.

Barry Ritholtz, market strategist at brokerage Maxim Group in New York, says the severity of the tech stock bust has left many investors seeing its ghost everywhere. The result, he said, is that ''we have a bubble in bubbles'': Any market that has big numbers attached to it becomes a candidate for bubble-hood.

As Ritholtz points out, however, ''being overpriced is not the same as being a bubble.'' In a capitalist system, investment values are forever moving from underpriced to fairly priced to overpriced and back. That's the nature of free markets.

But true bubbles on the scale of dot-coms in the late 1990s, or Japanese stocks in 1988-89, or tulip bulbs in 1636-40, are relative rarities.

The dictionary definition of ''bubble,'' in the financial context, may be helpful here: ''any idea that seems plausible at first but quickly shows itself to be worthless or misleading.''

Home prices may be inflated, particularly on both U.S. coasts, but there is some value in every livable house. Likewise, a barrel of oil has some worth, because it's good for something — it can power your car.

A barrel of tulips, by contrast, isn't very useful today, and probably wasn't in 1640 either.

Jeremy Grantham, chairman of money manager Grantham, Mayo, Van Otterloo & Co. in Boston, allows that a durable wooden roof over your head has more value than, say, a piece of cardboard papered with dot-com stock certificates.

But he counts himself as more worried about a financial mega-bubble than many of his peers on Wall Street.

Grantham contends that most stocks and bonds, and many residential real-estate markets, are far overvalued and must decline substantially in price by the end of this decade.

He believes the blue-chip Standard & Poor's 500 stock index should fall to about 730 to be ''fairly valued.'' That would be a drop of about 35 percent from Friday's closing level. And yields on high-risk corporate bonds should be significantly above current levels, by his estimation.

Grantham also concedes that he has been predicting a financial unraveling for the last two years and has been dead wrong. ''We were horribly early,'' he said.

But his reasoning hasn't changed, Grantham said: The Federal Reserve, by cutting interest rates to generational lows in recent years, inflated a new crop of financial market bubbles by giving investors the wherewithal to aggressively bid up the values of bonds, real estate and (once again) stocks, he said. That's what easy money will do, and that's what it did, in his view.

The Fed ''tried to get us off the hook from the stock bubble [of 2000], and as a consequence a lot of other assets became more expensive,'' Grantham said.

With the Fed now tightening credit, it is taking away the source of asset inflation, he said. That makes it more logical to assume that prices of those assets are headed lower rather than higher, especially given how high prices have risen, he said.

It's a simple premise, and perhaps too simple for a complex global marketplace in which investors often aren't bound by logic, or by one man's opinion.

What we know about bubbles is that when you're inside them, it's often hard to recognize that fact. The people of 2010 may have to make that judgment for us.

Tom Petruno is a reporter for the Los Angeles Times, a Tribune Publishing newspaper.

5 Comments:

At 3:09 PM, Blogger Barry Ritholtz said...

Funny you posted this article that I'm in -- I just mentioned your blog in a page of housing/real estate blogs

You can see it here:

http://bigpicture.typepad.com/comments/2005/05/real_estate_blo.html

 
At 5:37 PM, Anonymous Anonymous said...

I think a mega-bubble is highly unlikely. You will always have doomsayers like Jeremy Grantham. Sometimes they will get lucky and what they predict will happen (Robert Shiller author of Irrational Exuberance who predicted the tech crash is an example). However, the doomsayers are usually wrong. Of course, they make lots of money writing scary books. Negativity can be very profitable.

 
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