Bubbles in the Making
In October of 2009, I wrote in my blog about the economic and capital market bubbles we’ve struggled through, what caused them and the outcomes. While economic and capital market bubbles are continuously forming, I see strong evidence of specific bubble formation, not particularly good news following the short recovery from the 2008 global meltdown.
Artificially low interest rates. The current policy of keeping interest rates below 1% in much of the developed world was intended to encourage consumers and small businesses to borrow. In reality, this has not been occurring since there has been very little lending by financial institutions, the exact same beneficiaries of the trillions of dollars of bail out money. These institutions, whose capital structure is now guaranteed by government, are starting to resume making risky investments. They are looking to participate in the next wave of structured investment vehicles (SIVs) and ‘high-yielding, lower risk’ opportunities that always draw waves of unsuspecting buyers. This behavior is driven by the egregious fee income earned by their investment banking departments, the outsized profits earned by their proprietary trading desk as they take advantage of investors’ inexperience with such securities and the extreme commissions earned by their brokerage departments, who will peddle these securities just long enough to take the lion’s share of the profits. After nearly two years, the failure by Congress to implement regulatory reform over U.S. financial institutions is by default, contributing to another capital market meltdown.
Emerging Markets and U.S. Debt. It doesn’t matter whether you buy equity or fixed income, emerging markets are being promoted as the next no brainer, free lunch investment opportunity. There is tremendous optimism being sold to investors on the growth potential of these new economies. Thanks to their increasing exports and having largely withstood the ravages of the 2008 capital markets meltdown, these economies have played a major role in funding U.S. deficits. Before long, these countries will shift their investments away from buying U.S. debt and reinvest in their own growing economies. As evidenced in the past, a bubble bursts when the buyers turn and run.
Price-Earnings Ratio and Market Valuation. This often misused stock valuation measure looks at a company’s, an industry’s or a stock index’s current price in relationship to future earnings expectations. This single measure is often used to promote equity investments and assess their current investment attractiveness. Given this ratio is based on “future earnings per share”, it becomes obvious that this measure is subjective, easily manipulated and often misinterpreted. The sad result is people are lured into investments that may not be as fairly priced or attractive, as the P/E ratio would suggest. For example, the MSCI World Trade Index (an index of global stocks) is trading on a multiple of 14 based on projected earnings for 2010. If you instead look at the cyclically adjusted price-earnings ratio, which averages corporate earnings over the previous 10 years, the multiple jumps up to 20, a nearly 50% higher market valuation than the widely quoted P/E of 14.
