Is the U.S. in a bubble now?
Investor’s Daily Edge
July 10, 2007
By Andrew Gordon
Dictionary.com defines bubble as “an inflated speculation, especially if fraudulent.” Frankly, I’m surprised about the “fraudulent” part. Since when do you need fraudulence to get a nice big bubble going? All you need is easy money and lots of people getting carried away.
And we’ve got that in spades.
Was the Japanese property bubble fraudulent? No, it wasn’t.
Was the millennial tech bubble fraudulent? No, it wasn’t. Stupid? Yes. Avoidable? One would think. And sure, there were some CEOs from that period who lied to shareholders and stole their money, but that didn’t cause the bubble.
The biggest bubbles today? The Shanghai Stock Exchange, without a doubt. It’s trading at a 43-percent premium to the same stocks traded on the Hong Kong exchange and shares have increased more than 50 percent since the beginning of the year.
India’s market is bubbling its way to new highs. It has climbed more than 70 percent in the 12 months to mid-June.
Fearless investing – or should I say dumb investing by fearless investors – has led to inflated assets wherever you turn.
For example, why in the world is the debt of countries like Colombia trading at less than two percentage points above U.S. Treasurys (compared to 10 percentage points five years ago)?
But let’s forget about numbers for a second. You really don’t need them to recognize a bubble. Believe me, if you’re in the middle of an asset bubble, you know it.
Here in south Florida as recently as last year, the only thing taxi drivers would talk to me about was real estate. When the guy picking up my trash told me he was investing in a third condo, I knew it was a bubble for sure.
Southeast Asia saw a big run-up in assets in the 1990s. If you spent any time there like I did during those years, you’d know it right away. Everybody thought they had the inside track to the next $10 million deal. Financing? No problem. The country was drowning in cash. And everything – from mines to Internet ventures – was on the table. By 1998, the bubble had burst.
So, is the U.S. in a bubble now?
Apart from real estate in certain parts of the country like south Florida, California, and the East Coast, it sure doesn’t feel like it.
The overhang in housing inventory varies dramatically from place to place in the U.S. It’s not a true national bubble.
And even though the S&P 500 hit a record high on May 30, its P/E averages 16, which historically is not a high number.
By feel and by numbers, it seems like we’re not in a bubble.
And yet, there are clues that we shouldn’t be so complacent.
Is it just a coincidence that the asset class that went up the most in the U.S. in the past five years – homes – is suffering from a surge of defaults from its most vulnerable group of investors: homeowners with weak credit?
Is it just a coincidence that last week there was a spike in interest rates for riskier borrowers?
I don’t believe so.
In fact, the subprime crisis appears to be just the tip of the iceberg (as opposed to being the iceberg itself).
This is not news to one group of economists who call themselves the Austrian School – named for its Austrian-born proponents, Ludwig von Mises, Joseph Schumpeter, and Friedrich Hayek. And one of its many adherents – William White – heads the economic and monetary department of the Switzerland-based Bank of International Settlements (BIS).
In its recently released annual report, the BIS said, “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [which] … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”
So, this is what we know.
Assets all over the world have been increasing in value since the middle of 2003 on the back of low inflation and easy money.
The Alt-A (a category between prime and subprime) home mortgage market is also seeing defaults rising.
Bonds defined as BB+ and below have recently traded at a smaller risk premium over U.S. Treasurys than ever before in history. It shrunk to 2.63 percentage points compared to an average of 5.42 percentage points during the last 20 years.
Last year, a record 21 percent of new high-yield lending was to marginal borrowers (those with at least one rating starting with a "C"). It’s gotten worse this year. A full third of high-yield lending has gone to these iffy borrowers.
Last year, just 0.8 percent of high-yield bonds defaulted – the lowest in modern times. And this year has seen only three defaults so far.
This, my friends, is the proverbial calm before the storm.
What’s the difference between Japanese banks in the 1980s feeding cheap loans to local companies bleeding red and U.S. banks now feeding covenant-lite loans (loans with “mańana” repayment terms) to target takeover companies being loaded up with debt?
The scary truth is, there’s no difference at all.
The Austrian school thinks that easy credit and investor exuberance is a toxic combination. Their solution would be to raise rates.
But members of the Fed aren’t admirers of the Austrian School. Higher rates are only used to fight off inflation, not deflate assets.
I don’t believe we’re at the tipping point yet. But certainly it’s not too early to increase your gold holdings. Gold prices have come down recently. This would be a good time to buy.
If we’re lucky, we may dodge a bullet. Big-money investors are finally showing some restraint by rejecting a recent round of covenant-lite bond offerings.
It’s a start. And if it continues, it could very well lead to a market correction. But considering the alternative, that wouldn’t be such a bad thing.
[Ed. Note: Recently, Andrew led Wealth Advantage readers to gains of over 219% on Energy Metals.]
About Andrew Gordon and Investor’s Daily Edge (www.investorsdailyedge.com)
Mr. Gordon has a Master’s Degree from the London School of Economics and over 25-years of experience. He’s also authored six books on the global markets, including China’s Oil and Gas Industry, and The World Coal Market. Mr. Gordon specializes in identifying deep value companies with a solid margin of safety as well as income investments with a strong potential for capital gains. He has also become a leading expert in utilizing Exchange Traded Funds (ETFs) to profit from rising and falling market sectors. Mr. Gordon is currently the Editor-in-Chief of two monthly investment research services – INCOME and The Wealth Advantage.
Dictionary.com defines bubble as “an inflated speculation, especially if fraudulent.” Frankly, I’m surprised about the “fraudulent” part. Since when do you need fraudulence to get a nice big bubble going? All you need is easy money and lots of people getting carried away.
And we’ve got that in spades.
Was the Japanese property bubble fraudulent? No, it wasn’t.
Was the millennial tech bubble fraudulent? No, it wasn’t. Stupid? Yes. Avoidable? One would think. And sure, there were some CEOs from that period who lied to shareholders and stole their money, but that didn’t cause the bubble.
The biggest bubbles today? The Shanghai Stock Exchange, without a doubt. It’s trading at a 43-percent premium to the same stocks traded on the Hong Kong exchange and shares have increased more than 50 percent since the beginning of the year.
India’s market is bubbling its way to new highs. It has climbed more than 70 percent in the 12 months to mid-June.
Fearless investing – or should I say dumb investing by fearless investors – has led to inflated assets wherever you turn.
For example, why in the world is the debt of countries like Colombia trading at less than two percentage points above U.S. Treasurys (compared to 10 percentage points five years ago)?
But let’s forget about numbers for a second. You really don’t need them to recognize a bubble. Believe me, if you’re in the middle of an asset bubble, you know it.
Here in south Florida as recently as last year, the only thing taxi drivers would talk to me about was real estate. When the guy picking up my trash told me he was investing in a third condo, I knew it was a bubble for sure.
Southeast Asia saw a big run-up in assets in the 1990s. If you spent any time there like I did during those years, you’d know it right away. Everybody thought they had the inside track to the next $10 million deal. Financing? No problem. The country was drowning in cash. And everything – from mines to Internet ventures – was on the table. By 1998, the bubble had burst.
So, is the U.S. in a bubble now?
Apart from real estate in certain parts of the country like south Florida, California, and the East Coast, it sure doesn’t feel like it.
The overhang in housing inventory varies dramatically from place to place in the U.S. It’s not a true national bubble.
And even though the S&P 500 hit a record high on May 30, its P/E averages 16, which historically is not a high number.
By feel and by numbers, it seems like we’re not in a bubble.
And yet, there are clues that we shouldn’t be so complacent.
Is it just a coincidence that the asset class that went up the most in the U.S. in the past five years – homes – is suffering from a surge of defaults from its most vulnerable group of investors: homeowners with weak credit?
Is it just a coincidence that last week there was a spike in interest rates for riskier borrowers?
I don’t believe so.
In fact, the subprime crisis appears to be just the tip of the iceberg (as opposed to being the iceberg itself).
This is not news to one group of economists who call themselves the Austrian School – named for its Austrian-born proponents, Ludwig von Mises, Joseph Schumpeter, and Friedrich Hayek. And one of its many adherents – William White – heads the economic and monetary department of the Switzerland-based Bank of International Settlements (BIS).
In its recently released annual report, the BIS said, “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [which] … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”
So, this is what we know.
Assets all over the world have been increasing in value since the middle of 2003 on the back of low inflation and easy money.
The Alt-A (a category between prime and subprime) home mortgage market is also seeing defaults rising.
Bonds defined as BB+ and below have recently traded at a smaller risk premium over U.S. Treasurys than ever before in history. It shrunk to 2.63 percentage points compared to an average of 5.42 percentage points during the last 20 years.
Last year, a record 21 percent of new high-yield lending was to marginal borrowers (those with at least one rating starting with a "C"). It’s gotten worse this year. A full third of high-yield lending has gone to these iffy borrowers.
Last year, just 0.8 percent of high-yield bonds defaulted – the lowest in modern times. And this year has seen only three defaults so far.
This, my friends, is the proverbial calm before the storm.
What’s the difference between Japanese banks in the 1980s feeding cheap loans to local companies bleeding red and U.S. banks now feeding covenant-lite loans (loans with “mańana” repayment terms) to target takeover companies being loaded up with debt?
The scary truth is, there’s no difference at all.
The Austrian school thinks that easy credit and investor exuberance is a toxic combination. Their solution would be to raise rates.
But members of the Fed aren’t admirers of the Austrian School. Higher rates are only used to fight off inflation, not deflate assets.
I don’t believe we’re at the tipping point yet. But certainly it’s not too early to increase your gold holdings. Gold prices have come down recently. This would be a good time to buy.
If we’re lucky, we may dodge a bullet. Big-money investors are finally showing some restraint by rejecting a recent round of covenant-lite bond offerings.
It’s a start. And if it continues, it could very well lead to a market correction. But considering the alternative, that wouldn’t be such a bad thing.
[Ed. Note: Recently, Andrew led Wealth Advantage readers to gains of over 219% on Energy Metals.]
About Andrew Gordon and Investor’s Daily Edge (www.investorsdailyedge.com)
Mr. Gordon has a Master’s Degree from the London School of Economics and over 25-years of experience. He’s also authored six books on the global markets, including China’s Oil and Gas Industry, and The World Coal Market. Mr. Gordon specializes in identifying deep value companies with a solid margin of safety as well as income investments with a strong potential for capital gains. He has also become a leading expert in utilizing Exchange Traded Funds (ETFs) to profit from rising and falling market sectors. Mr. Gordon is currently the Editor-in-Chief of two monthly investment research services – INCOME and The Wealth Advantage.
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