All the World's a Bubble

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Jeremy Grantham: All the World's a Bubble

By Brett Arends
Mutual Funds Columnist
4/27/2007 10:07 AM EDT

How high will the Dow go? 15,000? 20,000?

How about 36,000?

While euphoria sweeps stock markets here and worldwide, there are at least a few voices of dissent.

One, unsurprisingly, is legendary value investor Jeremy Grantham -- the man Dick Cheney, plus a lot of other rich people, trusts with his money. Grantham, chairman of Boston firm Grantham Mayo Van Otterloo, has been a voice of caution for years. But he has upped his concerns in his latest letter to shareholders. Grantham says we are now seeing the first worldwide bubble in history covering all asset classes.

Everything is in bubble territory, he says.

Everything.

"From Indian antiquities to modern Chinese art," he wrote in a letter to clients this week following a six-week world tour, "from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it's bubble time!"

"Everyone, everywhere is reinforcing one another," he wrote. "Wherever you travel you will hear it confirmed 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.' "

As Grantham points out, a bubble needs two things: excellent fundamentals and easy money.

"The mechanism is surprisingly simple," he wrote. "Perfect conditions create very strong 'animal spirits,' reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism."

And it becomes self-sustaining. "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."

It's something to think about the next time you hear someone tell you that the stock market will keep rising simply because the world economy is doing so well. That would make sense only if we were paying a constant price for each unit of world GDP, instead of higher and higher prices for one slice of that GDP -- equity.

Grantham concludes that every asset class is expensive today compared with historic averages and compared with the cost of replacing it. By his calculations, the only assets likely to beat inflation by any significant margin if you hold them for the next seven years are managed timber, "high-quality" U.S. stocks, and bonds.

As noted in this column several weeks ago, Grantham's U.S. "high-quality" stocks include Home Depot (HD) , Merck (MRK) , Wal-Mart (WMT) , AT&T (T) , Pfizer (PFE) , Johnson & Johnson (JNJ) , Exxon Mobil (XOM) , UnitedHealth (UNH) , Verizon (VZ) and Lowe's (LOW) .

"The bursting of [this] bubble will be across all countries and all assets, with the probable exception of high-grade bonds," Grantham warned. "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 confidence and lower economic activity."

Ouch.

Grantham sees two big potential catalysts that might turn this bull market into a bear: a surge in inflation, leading to higher interest rates, and a squeeze on profit margins, which are currently running way above long-term averages.

As for timing, he concedes that's impossible to predict. But here's the kicker: Even Grantham thinks you probably need to be bullish right now. The reason? Most bubbles, he notes, go through a short but dramatic "exponential phase" just before they burst. Like Japan in 1989 or the Internet in early 2000.

"My colleagues," wrote Grantham, "suggest that this global bubble has not yet had this phase and perhaps they are right. ... In which case, pessimists or conservatives will take considerably more pain."

Housing Bubble and Real Estate Market Tracker

Housing Bubble and Real Estate Market Tracker

Posted on Mar 28th, 2007

Two Spillovers from the Bursting of Two Bubbles: Stephen Roach

Global
Asian Decoupling Unlikely
March 26, 2007

By Stephen S. Roach | New York

As the US economy slows, most believe that Asia’s growth machine will fill the void. Don’t count on it. Policy makers in China and India are shifting toward restraint, tilting growth risks in the region’s fastest-growing economies to the downside. Nor is an externally-dependent Japanese economy likely to provide much compensation. To the extent the case for global decoupling is dependent on an Asian offset, prepare to be disappointed.

After years of doubt, convictions are deep that both China and India will stay the course of hyper-growth. There has been talk for years about the coming Chinese slowdown, but so far the downshift has failed to materialize. The 10.7% increase in Chinese GDP in 2007 was the fastest since 1995, when the size of the economy was less than one-third what it is today. Moreover, with India now showing impressive improvement in its macro foundations of growth – especially saving, infrastructure, and foreign direct investment – there is good reason to believe that there may be considerable staying power to the recent acceleration in economic growth that averaged 9% during the 2005-06 interval.

Incoming data give little reason to doubt the staying power of the Asian growth machine. Chinese industrial output growth has reaccelerated to an 18.5% y-o-y pace over the January-February period – up from the sub-15% comparison in the final period of 2006 and only a shade slower than the 19.5% gains recorded last June. While India’s industrial production growth is certainly not as brisk as China’s, the 10% y-o-y comparison in early 2007 remains well above the 7¼% pace that was evident in late 2005 and early 2006. Needless to say, if China and India stay their present course, the global economy would barely skip a beat in the face of a US slowdown. Collectively, China and India account for about 21% of world GDP, as measured by the IMF’s purchasing power parity framework – essentially equal to the 20% share the statisticians assign to the United States. Add in the recent acceleration in the Japanese economy – a 5.5% annualized increase in the final quarter of CY2006 for an economy that accounts for another 6% of PPP-based world GDP – and there is good reason to believe that the impact of America’s downshift could well be neutralized by the ongoing vigor of the Asian growth machine.

The Asian offset, in conjunction with a modest cyclical uplift in a long sluggish European economy, is the essence of the case for global decoupling – a world economy that has finally weaned itself from the great American growth engine. A key presumption of that conclusion is that Asia can stay its present course. There are two flaws in that argument, in my view – the first being that internal pressures are now building in Asia’s fastest-growing economies that could be sowing the seeds for slower growth ahead. In particular, both the Chinese and Indian economies are now displaying worrisome signs of overheating. In China, the symptoms have manifested themselves in the form of imbalances in the mix of the real economy, widening disparities in the income distribution, and a large and growing current-account surplus – to say nothing of the negative externalities of environmental degradation and excess resource consumption. In India, the overheating has surfaced in the form of a cyclical resurgence of inflation, with the CPI running at a 6.8% y-o-y rate in early 2007 – a sharp acceleration from the 3.8% pace of 2002-05.

In recent weeks, I have met with senior policy makers in both China and India. It is clear to me that in both cases the authorities are in the process of shifting their policy arsenals toward meaningful restraint. In China, the direction comes from the top in the form of growing concerns expressed by Premier Wen Jiabao about a Chinese economy that he has explicitly characterized as “unstable, unbalanced, uncoordinated, and unsustainable” (see my 19 March dispatch of the same name). Since those words were first uttered at the end of the National People’s Congress on 15 March, Chinese authorities have been quick to respond. There was a monetary tightening the very next day and the securities industry regulators have issued new rules that prevent companies from purchasing equities with proceeds from share sales. The former move is aimed at cooling off an overheated investment sector while the latter move is addressed at dealing with a frothy domestic stock market that increased by 100% in the six months ending in late February. I am more convinced than ever that Beijing is now deadly serious in attempting to regain control over its rapidly growing economy in an effort to shift the focus from the quantity to the quality of growth. This is good news for China but could be disappointing for the decoupling camp that expects rapid Chinese economic growth to remain resistant to any downside pressures.

India is similarly positioned. The Reserve Bank of India does not take overheating and cyclical inflationary pressures lightly. I was actually in Mumbai the day the RBI tightened monetary policy last month (13 February), and it was clear to me in my discussions at the central bank that it meant business. The RBI’s official statement following that action said it all: “(A) determined and co-ordinated effort by all to contain inflation without unduly impacting the growth momentum is not only an economic necessity but also a moral compulsion.” Our Indian economics team underscores the risk of another monetary tightening prior to the 24 April policy meeting. At the same time, the government’s annual budget contained measures that would cut tariffs on food and other price-sensitive manufactured products. Indian authorities are fixated on a mounting cyclical inflation problem and appear more than willing to take a haircut on economic growth to achieve such an objective. Our current economic forecast reflects just such an outcome – a downshift to 6.9% GDP growth in 2008 following average gains of 8.7% over the 2005-07 period.

There is a second factor at work that is also likely to challenge the view that hyper growth is here to stay in Asia – the region’s persistent reliance on external demand as a major driver of economic growth. This is less a story for India, with its relatively small trade sector, and more a story for the rest of Asia. China is at the top of the external vulnerability chain. Its export sector, which rose to nearly 37% of GDP in 2006, surged at a 41% y-o-y rate in the first two months of 2007. Moreover – and this is an absolutely critical point in the decoupling debate – the United States is China’s largest export market, accounting for 21% of RMB-based exports. As the US economy now slows, the biggest piece of China’s export dynamic is at risk. So, too, are the large external sectors of China’s pan-Asian supply chain – especially Taiwan, Korea, and even Japan. Lacking in self-sustaining support from private consumption, the Asian growth dynamic remains highly vulnerable to an external shock. That’s yet another important reason to be very suspicious of the case for global decoupling.

Decoupling and global rebalancing go hand in hand. A decoupled world is very much a rebalanced world – and vice versa. Recent trends admittedly lend some support to the decoupling thesis – especially a booming Asia economy but also a seemingly remarkable cyclical revival in Europe. The European upsurge is a welcome development, but perspective is key. At most, it will add 0.2 to 0.3 percentage point to our baseline case for world economic growth. Asia, especially China and India, is a very different story. This is a much larger segment of the global economy and is growing at rates that are three times as fast as those in the developed world. An Asian economy that only barely widens its growth multiple relative to the rest of the world could well drive global decoupling on its own.

That’s unlikely to be the case, in my view. Not only does Asia remain vulnerable to a US-centric external shock, but the region’s two most powerful growth stories – China and India – are now both very focused on matters of internal sustainability. The Premier of China has put his reputation on the line in attempting to bring an unstable, unbalanced, uncoordinated, and unsustainable Chinese economy under control. The Indian government is equally focused on an anti-inflationary policy tightening. Looking backward, both of these economies have been on an exceptionally strong growth path that – if left to its own devices – could play an increasingly important role in powering a decoupled world. Looking forward, however, it’s likely to be a very different story. With growth prospects in China and India tipping to the downside at the same time the US economy is slowing, the global economy is likely to be a good deal weaker than the decoupling crowd would lead you to believe.

Mortgage Meltdown: Wall Street Journal indicts Greenspan

Mortgage Meltdown

By Andy Laperriere

Stock markets world-wide have sold off the past few weeks over concerns the collapse of the subprime mortgage industry could prolong and deepen the housing slump and threaten the health of the U.S. economy. Federal Reserve officials and most economists believe the problems in the subprime mortgage market will remain relatively contained, but there is compelling evidence that the failure of subprime loans may be the start of a painful unwinding of a housing bubble that was fueled by easy money and loose lending practices.

***

The fact that Congress is now holding hearings on the fallout from the second major asset price bubble in the last decade should prompt some broader questions. For example, what role did the Fed's loose monetary policy from 2002-2004 play in fueling the housing bubble? Should the Federal Reserve reexamine its policy of ignoring asset bubbles?

Asset bubbles are harmful for the same reason high inflation is: Both create misleading price signals that lead to a misallocation of economic resources and sow the seeds for an inevitable bust. The unwinding of today's housing bubble is not merely an academic question; it is likely to inflict real hardship on millions of Americans. To reduce the risk of a similar outcome in the future, it is important that policy makers, economists, and policy analysts properly diagnose the root causes of the current housing bust, not just its symptoms.

***

Federal Reserve officials and most economists believe the problems in the subprime mortgage market will remain relatively contained, but there is compelling evidence that the failure of subprime loans may be the start of a painful unwinding of a housing bubble that was fueled by easy money and loose lending practices.

Whether measured in absolute terms or time-tested metrics such as price-to-income or price-to-rent ratios, the rise in U.S. home prices during the past six years is unprecedented. What's more, not only has mortgage debt doubled during this time, but loans have been offered on imprudent terms (for instance, a no down payment, no income verification loan to a borrower with a checkered credit history).

***

Far from being limited to the subprime market, the data show these risky loan features have become widespread. According to Credit Suisse, the number of no or low documentation loans -- so-called "liar loans" -- has increased to 49% last year from 18% of purchase loans in 2001, a nearly three-fold increase. The investment bank also found that borrowers put up less than a 5% down payment in 46% of all home purchases last year. Inside Mortgage Finance estimates that nontraditional mortgages -- mostly interest-only and pay-option ARMs that allow the borrower to defer paying back principal or even increase the loan balance each month -- which barely existed five years ago, grew to close to a third of all mortgages last year.

***

Foreclosure losses as a share of the economy will be small and most homeowners have a comfortable amount of equity in their homes. In fact, about one-third of homeowners have no mortgage and own their homes outright, but they are not the reason home prices have been driven to the stratosphere. Home prices -- like all prices -- are set at the margin.

It was the marginal buyer, particularly the subprime borrower and housing speculator, who drove prices higher. The easing of lending terms increased the demand for homes, and since the supply of homes is relatively fixed (or inelastic), this increase in demand quickly translated into higher prices. As the loose lending practices are inevitably reversed -- and there is a wide chasm between current lending practices and prudent lending terms -- fewer people will be able to afford to buy a house, which will reduce demand and push home prices lower.

***

It's not the size of foreclosure losses as a share of the economy that matters, it is the effect those losses have on the availability of credit. When banks (and investors in mortgage-backed securities) begin suffering losses, they inevitably pull back. This is why so many subprime companies have gone bankrupt virtually overnight; investors balked at buying subprime loans except at a steep discount, which produced immediate losses. In effect, their ability to profitably finance new loans was eliminated.

***

Asset bubbles are harmful for the same reason high inflation is: Both create misleading price signals that lead to a misallocation of economic resources and sow the seeds for an inevitable bust. The unwinding of today's housing bubble is not merely an academic question; it is likely to inflict real hardship on millions of Americans. To reduce the risk of a similar outcome in the future, it is important that policy makers, economists, and policy analysts properly diagnose the root causes of the current housing bust, not just its symptoms.

Listen to Mr Greenspan - there's nothing so fragile as a bubble

William Keegan
Sunday March 11, 2007

Observer

After the January World Economic Forum I expressed some concern about the remarkable optimism - nay, complacency - manifested there about the course of the world economy. Earlier in the month I had quoted Herb Stein, an adviser to President Nixon in the 1970s (on economics, not burglary or cover-up). The quotation was: 'If something can't go on forever, it will probably stop.'
An alert reader challenged the 'probably' (which originated via an American economist 'correcting' Professor Wynne Godley, who had used the quotation without 'probably'), and sent me an article written by Stein himself, in which 'probably' does not appear, and 'cannot' (rather than 'can't') does.

You pays your money and you takes your choice. It often happens with famous quotations. Incidentally, Stein quotes Nixon as having once said: 'Honesty may not be the best policy, but is worth trying once in a while.' That may explain quite a lot. Anyway, Stein tells us that 'Stein's Law' was first pronounced in the 1980s, and elaborates thus: 'This proposition, arising first in a discussion of the balance-of-payments deficit, is a response to those who think that if something cannot go on forever, steps must be taken to stop it - even to stop it at once.'

The implication, I take it, is that policymakers don't necessarily have to do anything about what will stop anyway. One does not know whether former Federal Reserve chairman Alan Greenspan had this in mind when saying last week about the so-called 'carry trade' (the huge amounts of money converted from yen to other currencies to take advantage of differentials between interest rates, which have driven the yen down and made Japanese exports more competitive than ever) that 'at some point it's got to turn'. But recent shenanigans in the financial markets seem to indicate that riskier investments are not as popular as they were.

So far, most of my fellow commentators seem to be relaxed about stock markets and the outlook for the world economy, and dismissive of Greenspan's assessment that there is a possibility of a US recession later this year.

The difference between Greenspan now and Greenspan when the great man was chairman of the Fed is that he can now say what he thinks, as opposed to what he thinks he ought to say. The reason for the insouciance of many financial market operators and commentators is that there is an assumption that the central banks (considered all-powerful except by central bankers themselves) can be relied upon to bail the US and other economies out as soon as trouble appears. There is empirical evidence for this in the past decade, and it is quite a contrast with the pre-Keynesian days of the inter-war years.

This is all very well as long as the central banks do not panic about inflation. There has been precious little reason to do so in recent years, because the weakening of the unions and the impact of 'globalisation' have together produced what is known in the trade as a 'benign' inflationary environment. Why, in Japan they have even been trying, without much tangible success, to inject a little inflation into the system.

As Professor Lord Desai puts it in his compulsively readable Marx's Revenge - The Resurgence of Capitalism and the Death of Statist Socialism: 'Democratic power can push the bargaining strength of the worker up to a certain point. If it threatens profitability too much, then capital withdraws or migrates .... Social-democratic parties everywhere [at the end of the 1980s] saw that restoration of profitability mattered once capital became mobile. But once it had become mobile, it demanded co-operation from the workers, not conflict. And it got that co-operation.'

It has become clear in recent months that trade unions are beginning to think they have been far too co-operative. One sees this in the bitter outbursts about the behaviour of hedge funds, private equity groups and senior corporate executives by such models of moderate trade unionism as John Monks, former general secretary of the TUC and now representing the much wider group of European trade unions.

One also sees it in the sporadic outbursts of discontent about low wage deals, not least in the UK public sector. But apart from the factors highlighted by Desai (whose book was published in 2002), we have witnessed the additional disinflationary factor in recent years of the remarkable influx of Continental workers to the UK - and not just from eastern Europe. French is rapidly becoming London's second language.

The small inflationary bubble of recent months has been associated with the lagged impact of earlier rises in the price of energy. Now the prospect is of lower energy prices later this year, and, according to the Governor of the Bank of England, Mervyn King, there is the possibility of quite a sharp fall in inflation. Yet there continue to be noticeable worries among central bankers about 'asset bubbles' - not least in housing.

A vogue phrase among financial regulators has been 'the underpricing of risk'. The convenient reaction to recent upheavals in the financial markets is that there has been a 'healthy and necessary correction'. Has been? All over? One wonders. The problem with the modern phenomenon whereby it is assumed that the central banks will always bail the system out is that there is an inherent bias in favour of bubbles and the traditional excesses of capitalism. There is an uneasy feeling in the air that all is not quite right.

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