A couple of articles from The Economist magazine.
Markets are too dependent on unsustainable government stimulus. Something’s got to give
THE effect of free money is remarkable. A year ago investors were panicking and there was talk of another Depression. Now the MSCI world index of global share prices is more than 70% higher than its low in March 2009. That’s largely thanks to interest rates of 1% or less in
For all the panic last year, asset values never quite reached the lows that marked other bear-market bottoms, and now the rally has made several markets look pricey again. In the American housing market, where the crisis started, homes are priced at around fair value on the basis of rental yields, but they are overvalued by almost 30% in
Stockmarkets are still shy of their record peaks in most countries. The American market is around 25% below the level it reached in 2007. But it is still nearly 50% overvalued on the best long-term measure, which adjusts profits to allow for the economic cycle, and is on a par with two of the four great valuation peaks in the 20th century, in 1901 and 1966.
Central banks see these market rallies as a welcome side- effect of their policies. In 2008, falling markets caused a vicious circle of debt defaults and fire sales by investors, pushing asset prices down even further. The market rebound was necessary to stabilise economies last year, but now there is a danger that bubbles are being created.
The danger of the bounce
Once again, cheap money is driving up asset prices
Spotting the signs
Is this policy approach creating yet another set of bubbles? Some, including Alan Greenspan, chairman of the Federal Reserve during the euphoria of the 1990s and early 2000s, believe that bubbles can be spotted only in retrospect. Others, such as Jeremy Grantham of GMO, a fund-management group, argue that they can be identified by a surge in prices (and valuations) to way above their previous trends.
In the model of market madness outlined by Hyman Minsky, a 20th-century American economist, and by Charles Kindleberger in his book “Manias, Panics, and Crashes”, bubbles start with a “displacement”—a shock to the financial system, perhaps in the form of a new technology such as railways or the internet. This provides the “narrative”—the rationale that persuades investors to join in. They start to believe that this time around things will be different and that asset prices can reach new heights.
The next stage is rapid growth in credit, which inflates the bubble. As investors borrow money to buy the asset in question, the resulting price rise makes the narrative more credible. At the peak, however, investors no longer pay much attention to fundamentals, buying simply on the belief that prices must rise further. This stage is marked by very high valuations and by popular enthusiasm for asset purchases—marked in the 1920s by shoeshine boys passing on share tips and in the early 2000s by the popularity of property programmes on television.
Eventually, like a Ponzi scheme, a bubble runs out of new buyers. Prices slump. “Euphoria” gives way to the final stage, “revulsion”—until the cycle can begin again.
If the authorities can do little to stop a bubble inflating, what can they do if markets suffer a further relapse? Interest rates cannot be reduced further and it is hard to see the markets tolerating even bigger budget deficits. That leaves quantitative easing (QE), the policy under which central banks create money to buy assets, usually government bonds. Even that may have its limits, if private investors decide to sell government bonds as fast as central banks try to buy them.
Bears argue that the global economy is already far too dependent on government stimulus. “Every basis point of [American] growth in [the third quarter] came from government stimulus, directly and indirectly,” says David Rosenberg of Gluskin Sheff, a Canadian asset-management firm. Schemes such as “cash for clunkers” temporarily boosted car sales but these quickly slipped again once government subsidies stopped. The latest example occurred when pending American home sales fell by 16% in November in anticipation of the end of a homebuyers’ tax credit (which has since been extended until the end of April).
These subsidies depend, in large part, on the ability of governments to fund huge deficits at relatively low cost. And that is perhaps the biggest issue of the moment.
The markets are beset by a series of contradictions. They are dependent on extraordinary amounts of government stimulus. But that stimulus is in turn ultimately dependent on the willingness of markets to finance governments at low rates. They should be willing to do so only if they believe that growth prospects are poor and inflation will stay low. But if they believe that, investors should be unwilling to buy equities and houses at above-average valuations. At some time—maybe in 2010—those contradictions will have to be resolved. And that will trigger another nasty bout of volatility.
Related previous post: Market Valuation, Revulsion, and a Few Things on the Horizon
Related books:A Short History of Financial Euphoria
Panic of 1819
The Panic of 1907
The Great Crash of 1929
The Go-Go Years
Bull: A History of the Boom and Bust, 1982-2004
Mr. Market Miscalculates