A Bubble In Bubbles
Having largely missed the last two bubbles, the popular press is on a mission to get the scoop on the next one. If you believe the press we now have bubbles in social networking stocks, commodities, gold, silver, oil, Chinese real estate, Australian real estate, US farmland, junk bonds, US stocks and emerging market stocks, just to name a few I’ve recently read about. It’s a veritable smorgasbord of bubbles. It appears we are in the midst of a bubble in bubbles or at least a bubble in articles about bubbles.
I don’t know if any of these things are actually bubbles. Certainly some of them appear to be out of whack with the historical fundamentals but asset prices are determined largely by expectations about the future. Is US farmland priced too dearly? Well, that depends to a large degree on the future prices of agricultural products which like everything in the future is unknown. Is gold overpriced? Compared to what? Are emerging market stocks overpriced? That depends to a large degree on the future price of various commodities and the value of the dollar which again are unpredictable. Anyone who claims to know when a current asset price represents a bubble is also making a claim of clairvoyance.
I don’t claim any such abilities but I do think there is an explanation for the plethora of “bubbles”. The common factor for all these “bubbles” is the falling value of the dollar. If there is a bubble right now it is in the number of people who have convinced themselves that the only future course of the dollar is the present one – namely down. As an investor I generally want to avoid the bosom of the crowd so I have begun to wonder if maybe, just maybe, the dollar’s declining ways are about to come to an end.
The Fed is nearing the end of its alchemical attempt to create prosperity from impoverishment known as QE II. There is little doubt that their goal of devaluing our way to growth has affected asset prices. The price of stocks and commodities have become highly correlated – and the dollar inversely so – with the Fed’s purchases of Treasuries. What happens when those purchases end? If the correlation holds, the logical assumption has to be that stocks and commodities will stop rising and the dollar will stabilize. And considering the size of the short position in the dollar, I think it is reasonable to assume the dollar might in fact rise as shorts cover their positions. If that does indeed come to pass it is also reasonable to expect that commodities at least will do the inverse.
I would also expect that the initial response of stocks will be negative. There is a belief – one I don’t share – that QE II has been positive for the economy. If one believes such nonsense its end should surely involve a degree of uncertainty about the future course of the economy. And stock market investors do not tend to react positively to new uncertainties about future growth. One other thing to consider is the effect on the bond market. If QE II raised inflation expectations and bond yields, shouldn’t its end do the opposite? Bonds may be a buy here.
Over the longer term, a rising dollar would be positive for the global economy as it is the source of so many of the current problems. Emerging markets are overheating due to capital inflows and too loose credit, both of which these countries are trying to rectify without much success. The weak dollar is the source of their troubles and reversing its decline would relieve a lot of the pressure. The US economy is also suffering from the weak dollar in the form of rising commodity prices, particularly oil. Assuming the US economy can continue to grow in the absence of government stimulus, lower commodity prices would be a significant positive for future growth.
A transition to a rising dollar environment will not be smooth. Over the last two years, investors have come to view a falling dollar as positive for risk assets and a rising dollar as negative – the so called risk on/risk off trade. Over the next few months it seems unlikely that view will change, but if economic growth can continue – or better accelerate – as the dollar stabilizes it will change eventually. It seems long forgotten now but US growth and the stock market performed pretty darn well with a rising dollar in the late 90s. We overdid the rising dollar thing back then which was a major cause of the internet “bubble” so after a rise the goal should be stabilization. Hmmm. One could say that our internet “bubble” was a result of excessive captial inflows. In fact, that period of US history is eerily similar to what is happening in emerging markets right now. Maybe we do have a bubble.
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