Friday, April 27, 2007


GDP at 1.3%

...and the Dow is up. As well as most of the other stock indices. Not surprising when you understand what is the catalyst for our economy: easy credit. You see, weak economic growth means that the price of credit, interest rates, are not likely to rise. As I have said before, when economic growth is the result of a bubble then the most important lynchpin to continued growth is keeping interest rates low.

So, you might be wondering, where are we now? The 1.3% GDP number on top of the continued weakness in the housing market is about as crystal clear as you can get. The one problem with this picture is the Terminatoresque stock market. Well, not so much of a problem when you understand the engine of growth has been the rising value of assets. Recently I saw a glaring example of a market pattern, a la Elliott wave, that made me say that we are far more likely to see higher prices in the stock market eventhough the economic signals are decidedly negative. This is not so strange because I have learned that the state of the economy is often not reflected in asset markets. It is the reason why I think the CAPM and efficient market hypothesis are poor ways to price stocks or consider the predictive power of technical analysis. So the fact that a weak GDP number, lower than the 1.8% estimate, did not hurt the stock market is unsurprising. This fact also makes it clear that the bubble is very powerful influence and this bit of knowledge should help us figure out what is going to happen next.

December 1999, you are here. I remember watching the stock market, the NASDAQ, in particular during this time. It was trading around 3500 at the time and its rise from 750 in 1994 was meteoric. Traders being who they are liked to short runaway markets and I was one of them. Luckily, I was trading small and keeping close stops because the run up from 3000 to 5000 in March, 2000 was just brutal for a lot of traders. My office was not far from the trading desk so I would sometimes walk over to give the clerks my orders and talk about what was going on. That is when I learned that I was not alone in trying to pick a top and I learned of a trader who just could not believe the NASDAQ could go from 3000 to 4000 to 5000 in 6 months. Well, he ran out of money before the market ran out of irrationality.

I think we are at that point where irrationality takes over and I am not alone.

Back in the 1999-2000 stock mania, my friend Jim Grant would on occasion call me while away from his office, asking: "What goes on?" To which I'd reply: "The market is open," meaning that by virtue of the market being open, it was up a ton, because that is in essence what was happening every day.

For those who don't recall, the reason that was the case was because we were supposedly in a new era, where productivity had trumped all of our problems, we were experiencing world peace and we would never, ever again feel the pain of the downside of the business cycle. Of course, what was really going on was that we had a bubble that was inspired by money printing.

Folks know how that ended, though the pain from the fallout of that bubble was never as extreme as it might have been, since the Federal Reserve successfully created a real estate bubble to bail out its burst equity bubble.


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.



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."


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." [Emphasis added.]

Needless to say, please read both articles. It is nice to be in the company of Grantham. If we are right and the bubble is entering a pre-bursting, bear punishing phase then this is an excellent time to move into the safest investments. Take a hard look at the quality of the bonds that you buy and to look forward to see if the unwinding of the bubble will cause them hardship. What it definitely is not time to do is to jump onto the bandwagon. We have had enough bubbles and disappointments at this point to be steely in our emotions when it comes to the next big thing that is making everyone rich.

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