Thursday, October 29, 2009

More Talk About Credit Bubbles

Bloomberg put up a headline this morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says”, Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”

We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.

“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”

“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”

According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.

Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.

How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?

In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: has also questioned current values in stock markets.

Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co,, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”,

Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.

According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.

A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha:

Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.

Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”

This is exactly the problem that I presented in my posts of October 26,, and October 27, The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.

Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.

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