Equity futures are down slightly this morning with the dollar higher, bonds lower, oil up slightly, gold higher, silver flat, and food commodities falling.
There is no significant economic data today, next week will bring Durable Goods, and a several pieces of information on housing.
How do you know for sure that you’re in a bubble? Launch ridiculous multi-billion dollar IPOs on companies with little earnings. LinkedIn’s share price doubled before launch, then doubled in the first couple of minutes after launch, reaching as high as $120 a share before pulling back into the mid $90 range.
This is a company that social networks for businesses – yes, a useful tool and a good concept, but based on current earnings that share price puts the price to earnings ratio into the 1,000+ stratosphere. That means that it would take more than a thousand years at current earnings to make the stock price whole. It’s definitely nuts to even discuss valuations like that as if they’re real - they’re not.
Again, what this type of thing really shows is that there is simply too much hot money sloshing around. Anyone considering “investing” in a market that is doing things like that is very likely to be disappointed with long term performance – to put it mildly.
The economic risk from Japan is still quite large. An independent group has taken measurements around Tokyo and has found radiation levels there are 5 times higher than what the government has admitted to. Imagine if they are forced to evacuate a 200 mile area or larger. What would that do to their economy? To their ability to service their tremendous debts? Japan is the world’s second largest economy (sorry China, but money printing and false data doesn’t make you second), there is great risk there for the economy.
But I’m sure that’s nothing they couldn’t just paper over with more dollars to create apparent growth, right? Wrong. That kind of hot money causes commodity inflation and rampant speculation bubbles that eventually burst. So, it’s time to republish the Hyman Minsky section from my book regarding bubbles to remind us how this ends:
HYMAN MINSKY’S SEVEN BUBBLE STAGES
The late Hyman Minsky, Ph.D., was a famous economist who taught for Washington University’s Economics department for more than 25 years prior to his death in 1996. He studied recurring instability of markets and developed the idea that there are seven stages in any economic bubble:
Stage One – Disturbance:
Every financial bubble begins with a disturbance. It could be the invention of a new technology, such as the Internet. It may be a shift in laws or economic policy. The creation of ERISA or unexpected reductions of interest rates are examples. No matter what the cause, the outlook changes for one sector of the economy.
Stage Two – Expansion/Prices Start to Increase:
Following the disturbance, prices in that sector start to rise. Initially, the increase is barely noticed. Usually, these higher prices reflect some underlying improvement in fundamentals. As the price increases gain momentum, more people start to notice.
Stage Three – Euphoria/Easy Credit:
Increasing prices do not, by themselves, create a bubble. Every financial bubble needs fuel; cheap and easy credit is, in most cases, that fuel. Without it, there can’t be speculation. Without it, the consequences of the disturbance die down and the sector returns to a normal state within the bounds of “historical” ratios or measurements. When a bubble starts, that sector is inundated by outsiders; people who normally would not be there. Without cheap and easy credit, the outsiders can’t participate.
The rise in cheap and easy credit is often associated with financial innovation. Many times, a new way of financing is developed that does not reflect the risk involved. In 1929, stock prices were propelled into the stratosphere with the ability to trade via a margin account. Housing prices today skyrocketed as interest-only, variable rate, and reverse amortization mortgages emerged as a viable means for financing overpriced real estate purchases. The latest financing strategy is 40, or even 50 year mortgages.
Stage Four – Over-trading/Prices Reach a Peak:
As the effects of cheap and easy credit digs deeper, the market begins to accelerate. Overtrading lifts up volumes and spot shortages emerge. Prices start to zoom, and easy profits are made. This brings in more outsiders, and prices run out of control. This is the point that amateurs, the foolish, the greedy, and the desperate enter the market. Just as a fire is fed by more fuel, a financial bubble needs cheap and easy credit and more outsiders.
Stage Five – Market Reversal/Insider Profit Taking:
Some wise voices will stand up and say that the bubble can no longer continue. They argue that long run fundamentals, the ratios and measurements, defy sound economic practices. In the bubble, these arguments disappear within one over-riding fact – the price is still rising. The voices of the wise are ignored by the greedy who justify the now insane prices with the euphoric claim that the world has fundamentally changed and this new world means higher prices. Then along comes the cruelest lie of them all, “There will most likely be a ‘soft’ landing!”
Stage Five is where the real estate industry is today [written in 2005/2006]. This stage can be cruel, as the very people who shouldn’t be buying are. They are the ones who will be hurt the most. The true professionals have found their ‘greater fool’ and are well on their way to the next ‘hot’ sector, like the transition from real estate to commodities now.Those who did not enter the market are caught in a dilemma. They know that they have missed the beginning of the bubble (gold, silver, and oil today [2005/2006]). They are bombarded daily with stories of easy riches and friends who are amassing great wealth. The strong will not enter at stage five and reconcile themselves to the missed opportunity. The ‘fool’ may even realize that prices can’t keep rising forever… however, they just can’t act on their knowledge. Everything appears safe as long as they quit at least one day before the bubble bursts. The weak provide the final fuel for the fire and eventually get burned late in stage six or seven.
Stage Six – Financial Crisis/Panic:
A bubble requires many people who believe in a bright future, and so long as the euphoria continues, the bubble is sustained. Just as the euphoria takes hold of the outsiders, the insiders remember what’s real. They lose their faith and begin to sneak out the exit. They understand their segment, and they recognize that it has all gone too far. The savvy are long gone, while those who understand the possible outcome begin to slowly cash out. Typically, the insiders try to sneak away unnoticed, and sometimes they get away without notice. Whether the outsiders see the insiders leave or not, insider profit taking signals the beginning of the end (remember who has sold their rental properties?).
Stage seven – Revulsion/Lender of Last Resort:
Sometimes, panic of the insiders infects the outsiders. Other times, it is the end of cheap and easy credit or some unanticipated piece of news. But whatever it is, euphoria is replaced with revulsion. The building is on fire and everyone starts to run for the door. Outsiders start to sell, but there are no buyers. Panic sets in, prices start to tumble downwards, credit dries up, and losses start to accumulate.
This is where you may see the “lender of last resort” who is usually the government. The government, although they were talking up a soft landing, are now forced to step in to prevent the crises from spreading to other sectors. Ironically, this is where the savvy investor who profited before, really profits now. With government backing, they are asked to step in and return “normalcy” to a now damaged sector.
The government’s attempt to “put out the fire” usually works. However, the conditions beyond the year 2010 will require oceans of water that the government does not posses. You must be ready!