Wednesday, November 26, 2014

Booming Until It Hurts?

NEW HAVEN – In recent months, concern has intensified among the world’s financial experts and news media that overheated asset markets – real estate, equities, and long-term bonds – could lead to a major correction and another economic crisis. The general public seems unbothered: Google Trends shows some pickup in the search term “stock market bubble,” but it is not at its peak 2007 levels, and “housing bubble” searches are relatively infrequent.

But the experts’ concern is notable and healthy, because the belief that markets are always efficient can survive only when some people do not completely believe it and think that they can profit by timing the markets. At the same time, this heightened concern carries dangers, too, because we do not know whether it will lead to a public overreaction on the downside.

International agencies recently issued warnings about speculative excesses in asset markets, suggesting that we should be worried about a possible crisis. In a speech in June, International Monetary Fund Deputy Managing Director Min Zhu argued that housing markets in several countries, including in Europe, Asia, and the Americas, “show signs of overheating.” The same month, the Bank for International Settlements said in its Annual Report that such “signs are worrying.”

Newspapers are sounding alarms as well. On July 8, the New York Times led its front page with a somewhat hyperbolic headline: “From Stocks to Farmland, All’s Booming, or Bubbling: Prices for Nearly All Assets around World Are High, Bringing Economic Risks.” The words “nearly all” are too strong, though the headline evinces the newfound concern.

It is not entirely clear why the alarms are sounding just now, after five years of general expansion in markets since they hit bottom in early 2009. Why aren’t people blithely expecting more years of expansion?

It seems that this thinking is heavily influenced by recent record highs in stock markets, even if these levels are practically meaningless, given inflation. Notably, just a month ago the Morgan Stanley Capital International All Country World Index broke the record that it reached on October 31, 2007.

The International Monetary Fund announced in June a new Global Housing Watch website that tracks global home prices and ratios. The site shows a global index for house prices that is rising, on a GDP-weighted basis, as fast as during the boom that preceded the 2008 crisis, though not yet reaching the 2006 record level.

There is also the US Federal Reserve’s announcement that, if the economy progresses as expected, the last bond purchase from the round of quantitative easing that it began in September 2012 will be in the month after the Federal Open Market Committee’s October 2014 meeting. That kind of news story seems also to affect observers’ thinking, though it is not really much in the way of news, given that everyone has known that the Fed would end the program before long.

The problem is that there is no certain way to explain how people will react to such a policy change, to any signs of price overheating or decline, or to other news stories that might be spun as somehow important. We simply do not have much well-documented history of big financial crises to examine, leaving econometricians vulnerable to serious error, despite studying time series that are typically no more than a few decades long.

Until the recent crisis, economists were talking up the “great moderation”: economic fluctuations were supposedly becoming milder, and many concluded that economic stabilization policy had reached new heights of effectiveness. As of 2005, just before the onset of the financial crisis, the Harvard econometricians James Stock (now a member of President Barack Obama’s Council of Economic Advisers) and Mark Watson concluded that the advanced economies had become both less volatile and less correlated with each other over the course of the preceding 40 years.

That conclusion would have to be significantly modified in light of the data recorded since the financial crisis. The economic slowdown in 2009, the worst year of the crisis, was nothing short of catastrophic.

In fact, we have had only three salient global crises in the last century: 1929-33, 1980-82, and 2007-9. These events appear to be more than just larger versions of the more frequent small fluctuations that we often see, and that Stock and Watson analyzed. But, with only three observations, it is hard to understand these events.

All seemed to have something to do with speculative price movements that surprised most observers and were never really explained, even years after the fact. They also had something to do with government policymakers’ mistakes. For example, the 1980-82 crisis was triggered by an oil price spike caused by the Iran-Iraq war. But all of them were related to asset-price bubbles that burst, leading to financial collapse.

Those who warn of grave dangers if speculative price increases are allowed to continue unimpeded are right to do so, even if they cannot prove that there is any cause for concern. The warnings might help prevent the booms that we are now seeing from continuing much longer and becoming more dangerous.

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    1. CommentedLuis de Agustin

      In an important client update this month, David Ranson, president and head of research for Wainwright Economics, advised that The US mini-boom is coming to an end.

      Despite proliferating turbulence in Ukraine and the Middle East, the net backup in credit spreads and implied volatility markets has been slight, and the US stock market has continued to roll along to new highs. Still, Dr. Ranson believes the stock market’s long advance is coming to an end – with a whimper rather than a bang.

      But there are signs of faltering in the economy as well as the stock market. Real growth in the second quarter was not nearly sufficient to make up for the hiccup in the first quarter, suggesting that not all of that setback can be attributed casually to the bad winter.

      In any case, if Wainwright’s interpretation is correct, the end of the good times is not far (although this was not inevitable – the secret being simply to keep capital flowing from abroad, particularly the emerging economies – to the US economy).

      Luis de Agustin

    2. CommentedEnrique Woll Battistini

      If the IMF, the World Bank, the IADB, and the major Central Banks were to take positions in real estate asset-based funds, REITS, and large real estate development projects, and divest themselves at times of "overheated asset markets," in coordination with the IMF, potentially explosive market bubbles would be deflated in time, avoiding market crashes, recessions and the possibility of depressions.

    3. CommentedFrank Ogilvie

      Given the near doubling of the the US M2 between 2007 and 2014, it seems unsurprising that asset prices have bubbled up. Particularly given the lack of any major wage or general price inflation. But how long will it last

    4. CommentedMichael Lupsor

      The Fed’s quantitative easing policy, promoted by the Federal Reserve, while not being able to prove tangible effects on reviving the American economy – if one ignores those studies written by the Fed itself – is showing its unintended consequences: a significant amount of funds going to the economies of developing countries in search of higher yields, and to margin accounts that are most probably behind a good part of the assets inflation. And the consequences of these consequences are yet to show their impact on the real economy.

    5. CommentedKevin McGivern

      Forecasting short or even medium term returns is an exercise for psychologists (or astrologers!). But "valuations matter" in a real economic sense; where asset valuations are right not its "bust" or "bleed", where "bleed " means the inexorable drip of present and future liabilities as they accrue. The returns needed simply won't be there to sustain the necessary wealth and the ability to fund liabilities.

    6. CommentedJon Quirk

      Analysing one side of an equation seldom sheds light; the issue is rather are asset prices seriously out of kilter with global growth and earnings potentials?

      Certainly asset prices in locations such as London are rising steeply but this is largely a function of rising risk in hotspots around the World and the seeking of safe havens.

      A certain level of tension in asset-pricing is healthy, and whist the present situation is on the high side, I don't think there is cause for concern just yet.

      Recall that, unlike Mr Shiller, I called 2007 before it happened, so don't think that a Nobel prize gives the holder any special insights.

    7. CommentedHeriberto Arribas

      In my opinion the question is secondary. The really important is that role playing bubbles in the economy. Are bubbles one adverse side effects? or will the bubble economy needs to work? Better not talk about bubbles but exuberance. Rational or irrational, it is subjective.
      From my point of view there are three periods of exuberance. At first from 1985 to 2001 in which the exuberance was growing without help. From 2001 to 2007 needs a little help from central banks through interest rates. And since 2008 the Central Banks have to directly inject money to keep the exuberance. Does the exuberance is rational and cracks an accident? or, is the exuberance is irrational and cracks is only the river that wants to return to his old bed.

    8. CommentedStefan S

      Asset prices are too high, good values are not to be found, and smart money is on the sidelines in cash positions, waiting.

    9. Commentedphilip meguire

      Divide the market value of all publicly traded stocks as of the end of the preceding year by the GDP of the current year. The resulting ratio for 2014 will be the second highest for any year post-WWII (2000 holds the record). Divide the median sales price of the median of a house that changes hands over a period, by the median household income over the same period. The values for 2014 will be the highest ever, except for 2005-07, especially outside of the interior of the USA, that happy land of cheap housing. These are the senses in which the American equity and housing markets are skating on thin ice.

        CommentedChris Cowsley

        Divide the amount of global money ($700 trillion according to Bain Capital) by the world population (7 billion mostly poor men, women, children & babes in arms). The answer is $100k per person. How can a 3% return be sustainable?

        The only way the investment circus hangs on is by attributing unrealisable increasing value to its asset base.

    10. CommentedGary Palmero

      Asset speculation invariably ends in one or more variations on this theme. Significant leverage is undertaken, leverage is supported by the asset being leveraged and many investors/speculators engage in the same activity at the same time. Some of the speculators are agents who benefit if the scheme succeeds but do not suffer if the scheme fails because the loss is passed onto the principal or socialized to others (mostly government agencies). When reckoning occurs, the debt cannot be paid, the loans are called and assets have to be liquidated compounded by many parties being forced into this position at once. Thus, the deluge.

      The next downturn may be interesting. The US has had a policy of near zero short term interest costs since 2009. This length is unprecedented in peace time in any Western industrial society. During that period, agency borrowing has been substantial with interest costs being extremely low. These agents tend to be non Federal government agencies. If there is ever an unanticipated event which forces interest rates to rise quickly, look out below.

    11. CommentedLuis de Agustin

      Indeed, Dr. Shiller has reason for concern, as much as there’s been concern about the “coming blowup” since the last devastation in ’08. David Ranson, head of research for Wainwright Economics has been the Cassandra for a day of reckoning as well for some time. His is more a concern with high inflation and a stagflation global environment. However, as someone who has to advise institutional investors in the here and now, Wainwright must come up with actionable ideas to manage the time waiting for the inevitable storm.

      Dr. Ranson notes there is indeed reason to think that the resilience of the global economy has increased since the enormous shakeup that accompanied the US financial crisis in 2008. This idea is reminiscent of the paradox that adversity generally makes human beings stronger rather than weaker.

      There certainly are reasons to think this, and we will have to wait and see how much stronger we are for the adversity of the Great Recession. For now, the advisory’s bullish case for US stocks continues, but with a nod to a possible developing side wind.

      The latest data for global economic uncertainty as expressed by corporate credit spreads show that the dismemberment of Ukraine and now Iraq has had unexpectedly little effect on these spreads. The Baa-Aaa yield spread reached 54 basis points this month and stands at 56 basis points, the lowest it’s been since 1997 for any length of time. Additionally, indexes of implied volatility for equities and bonds, which are also near historical lows, provide important confirmation of this interpretation.

      Only a snap of wind has hit the filled sails – by way of a change in the gold-price signal the company also uses. For now, the gold signal is pointing away from US stocks and bonds, and toward physical, foreign, and real assets. Yet, Wainwright cannot tell whether this change is going to be sustained, or is a blip originating from volatility in the indicators. Coupled, the indicators imply what the investment research house calls a wind towards spot commodities and emerging markets. Or, if one thinks of the gold price change as rather small relative to historical gold-price changes, maybe it’s a wind toward B-grade bonds. That is, good further gains in risky assets, but weaker performance on the part of the US stock market. The same indicators imply performance gains in assets such as commodities and emerging markets.

      Climbing walls of worry just isn’t enough while waiting for payback time.

      Luis de Agustin

    12. CommentedTom Shillock

      It is rather coy of Shiller to adopt the role of journalist as means to expressing his warnings. And it is amusing to find him denigrating market timing after a post-Nobel interview found him vaunting his ability at market timing since the 1970s.

    13. CommentedJersey Joe

      There is an asset class that always appears noticeably absent from these discussions of bubbles - that being precious metals. Precious Metals are also noticeably and obviously manipulated and far from inflation adjusted peak pricing.

      At least three times this week alone, thousands of futures were dumped on the markets in seconds (or less) at some of the most illiquid periods of the trading day - often in the dead of night or before major market openings. These futures represent underlying assets valued in the billions and are being sold in a manner designed to drive the prices down and are clearly not being sold in a manner to maximize return on the sale.

      These are not one-off events having have occurred dozens, if not hundreds of times, over the last few years. The silence on this manipulative fraud is overwhelm.

      Add to this the huge, oversized short positions of the major bullion banks that the CFTC has turned a blind eye on...and it speaks to systemic fraud in the trillions.

      One last point, in February of last year, Goldman Sacks put out a "Slam Dunk Sell" on gold which was followed by an estimate $20B futures dump on the COMEX. But ignored by the media was the fact that by August of that same year, Goldman Sacks showed up as one of the largest holders of the gold EFT (GLD). Odd wouldn't you say? Why was this obvious manipulation of investors Ignored?

      Since defaulting on Bretton Woods, we have all been led to believe that gold is just a barbaric relic. Well please tell that to the Chinese, Indians, Russians, Turks and Iranians - who have been emptying Western vaults of this relic.

        Commentedpieter jongejan

        I totally agree that the prices of gold and other metals are heavily manipulated today. But by who? After the Balfour declaration in november 1917 the exchange value of the dutch guilder and the swiss frank fell against the exchange values of the american dollar, the uk pound, the frech frank and even the german mark. The European countries ran out of gold, but their exchange rates rose against the countries with an oversupply of gold (see for data Norges bank). The reason is the same as always the banks want their money baack (Krugman, Summers and Delong as their servants) in gold. The banksters are preparing their exit. They love low interest rates and financial instability.

    14. Commentedpieter jongejan

      The FED continues to inflate the economy. By keeping interest rate at nearly zero debt ratios and asset prices continue to rise. Higher asset prices imply lower profit rates and lower investment ratios. Larry Summers and Paul krugman are right: secular stganation is here to stay. But they are wrong about the cause. The deepest cause is not insufficient demand, but the uktra low interest rate of the FED. Other countries, like the Eurocountries, have to foillow the ultra low interest rate of the Wall Street bankers, who run the FED. Institutionl reform of the FED is needed. But how? Wall street bankers (often from German descent like the Warburgs and the Rothschilds) control politicians and are not willing to cooperate.

        CommentedTravis Zly

        "Money" no longer is a measure of the "value of goods and services in an economy", but is actually a measure of "total value of debt in an economy". Debt is annualized for up to thirty years, but is traded in the markets as "Cash". According to a strict definition, "Equity = Assets - Liabilities". Since most European countries have Debt to GDP ratios close to 100% (or, in some cases way over 100%), they are technically insolvent. Creation of more debt by Central Banks as "stimulus" is only compounding the problem.
        Since commercial banks are not lending to the real economy in Europe (SMEs), Inflation only represents increases in Government debt or commercial debt/ IPOs of multinationals. European Governments are spending "debt" to try and reflate economies. Consequently "money" supply seems to be growing and inflation is apparently rising. In truth, the real economy of Europe is contracting. Statistics of inflation are meaningless as they only show increased activity in debt-markets (i.e. Bond Markets). Therefore economists and markets are taking erroneous positions because the definition of "money" is no longer valid. If a business sells all its goods on credit and none for cash, how can it be called a going concern? As one commentator on Twitter put it, all Euroopean banks are counterparties selling debt to each other. When their positions are unwound, there is no money left in Europe.
        I live in Cyprus, an economy that has no viable banking system since asset values have imploded and banks no longer have sufficient collateral.
        I should imagine the American "growth in asset value" is a mirage. It actually represents purchase of assets by an ever-expanding supply of debt-instruments. This is indeed unsustainable.

    15. CommentedWayne Davidson

      Financial prophecy, a vanity, a cognition conceived in a vacuum, devoid of consequence. RW

      "The error of thinking you know where you are going and assuming that you know today what your preferences will be tomorrow has an associated one. It is the illusion of thinking that others too, know where they are going, and that they would tell you what they want if you just ask theme.
      Never ask people what they want, or where they want to go, or where they think they should go, or, worse, what they think they will desire tomorrow".
      Nissim n Taleb. Antifragilty

    16. Commentedbilly osceola

      I never hear anyone talking about stock market now. In fact, bringing it up seems awkward. Index investing is boring but very profitable. People prefer tangible investments, like world Com or a local condo. No Bubble until this changes.

    17. CommentedJake Miller

      I respectfully disagree that “there is no certain way to explain how people will react to such a policy change, to any signs of price overheating or decline”… while we may not know precisely how people react, just like periods of high economic activity are followed by periods of low activity, periods of low expected returns (now) are always followed by periods of high expected returns. So too will this happen in the future - the business cycle is not dead.

    18. CommentedProcyon Mukherjee

      Prof. Shiller is spot on as we are in that moment of history where a de-growth in GDP in the first quarter coincided with the mammoth rally of the equity stocks, which apart from being a mere coincidence is a small reminder that with falling incomes and lack-luster growth rates the ability to make profits (which is what counts) cannot be augmented by the power and influence (apart from the share buy-backs) that large firms command, in absence of underlying positive fundamentals that has a strong directional element that stays in the same direction, with or without the stimulus.

    19. CommentedPaul Daley

      Capital gains tax rates tied to real interest rates, rising when real rates fall and vice versa? That would stifle asset price inflation and eliminate the windfalls that follow monetary policy moves. It would also ensure that more of the effects of any stimulus was channeled through income streams and felt in the real economy. Balance sheets would recover more slowly but how sensible is it to try to construct a recovery on the basis of windfalls? That really is the question that Shiller has raised.