I have identified the next bubble. It has already begun. It is in full swing.
Investors want to identify the next big bubble. Some investors want to buy in now, maybe using borrowed money (margin loans) to make a killing. They are confident that they will sell out near the top. They won't. Other investors just want to avoid getting trapped. They prefer to let the first group bear the uncertainty of profiting from a bubble sector.
The trouble with investment bubbles is that nobody seems to recognize them when they are making investors rich. Alan Greenspan denied that it is possible for central bankers to identify a bubble. He gave a speech in 2002, before his easy money policies had created the final stage of the worldwide housing bubble. He insisted on the following:
We at the Federal Reserve considered a number of issues related to asset bubbles — that is, surges in prices of assets to unsustainable levels. As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact — that is, when its bursting confirmed its existence.
Moreover, it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity — the very outcome we would be seeking to avoid.
First, he was blind to what the FED's policies had done in the second half of the 1990's to create the dot-com bubble. Second, he was equally blind to what these same expansionist policies were doing to the housing market — policies adopted in mid-2000, in response to the bursting of the dot-com bubble.
He was incorrect. Some of us did see that the dot-com bubble was a bubble. I told my subscribers in February and March of 2000 that the NASDAQ was a bubble at a price-earnings ratio of 206. The NASDAQ burst the week my second warning arrived in the mail.
With respect to the housing bubble, in late 2005, I wrote an article on "Surreal Estate on the San Andreas Fault," which warned against the coming bursting of the real estate bubble. It was clear to me what Greenspan had done to the economy.
If you remember the S&L crisis of the mid-1980s, you have some indication of what is coming. The S&L crisis in Texas put a squeeze on the economy in Texas. Banks got nasty. They stopped making new loans. Yet the S&Ls were legally not banks. They were a second capital market. Today, the banks have become S&Ls. They have tied their loan portfolios to the housing market.
I think a squeeze is coming that will affect the entire banking system. The madness of bankers has become unprecedented. They have forgotten about loan diversification. They have been caught up in Greenspan's counter-cyclical policy of lowering the federal funds rate. Now this policy is being reversed. Rates are climbing. This will contract the loan market. Banks will wind up sitting on top of bad loans of all kinds because the American economy is now housing-sale driven.
You may think that you are shielded. But your banker is not shielded. You may not deal with bankers. But your employer does.
If I saw it coming, why didn't Greenspan? Why didn't the pundits on CNBC? Why didn't the entire investment community? The real estate market still boomed through the first half of 2006. Then it began to falter. We all know what happened next.
It is not that no one can perceive a bubble while it is in progress. The problem is that investors who do not understand Ludwig von Mises' theory of the business cycle can't. They don't believe that central bank inflation causes the bubbles, and that these bubbles burst when the banks reverse their policies of monetary inflation. So, they and the advisors who cheer them on desperately want to believe the assurances by government officials and Federal Reserve Chairmen that no bubble is in progress, that there will be no regression to the mean.
The best way to identify a bubble is to look for investors who are rushing into an asset market and driving prices up to ludicrous ratios.
You can get 4.5% on a 30-year Treasury bond today. You pay $100 to get a guaranteed $4.50 a year in return: real money in your bank account (before income taxes). Meanwhile, the P/E ratio of the Standard & Poor's 500 index is at 120, if as-reported earnings are used instead of expected earnings. See the chart here.
At a P/E of 120, you pay $120 to get a hoped-for dollar of earnings (profits) for the latest reporting period. These profits are not dividends, just corporate profits.
This is a replay of 1999.
Two words: "consumer confidence."
We are told that consumer confidence has bounced back from its February 2009 low. It moved from 22 in February to 55 in May. This was a big jump. A spokesperson for the Conference Board, one of the main sources for this monthly survey, put it this way:
After two months of significant improvements, the Consumer Confidence Index is now at its highest level in eight months (Sept. 2008, 61.4). Continued gains in the Present Situation Index indicate that current conditions have moderately improved, and growth in the second quarter is likely to be less negative than in the first. Looking ahead, consumers are considerably less pessimistic than they were earlier this year, and expectations are that business conditions, the labor market and incomes will improve in the coming months. While confidence is still weak by historical standards, as far as consumers are concerned, the worst is now behind us.
Consumers listen to news reports. News reports speak of green shoots, parroting Ben Bernanke's pet phrase. That phrase has been picked up by the media, the same way that Greenspan's "irrational exuberance" was picked up when Greenspan used it in late 1996. Note: We should not ignore the context of Greenspan's remarks. It applies quite well to Bernanke's green shoots. Greenspan said this:
But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.
Balance sheets are crucial, he said. The #1 balance sheet in the American economy is the Federal Reserve's. It has doubled since last September. The Federal Reserve's economists did not see in August 2008 what a few weeks later Bernanke and Treasury Secretary Paulson described to senior members of Congress as a looming collapse of America's financial markets. They ignored the fact that the world's capital markets had seized up a year earlier, in August 2007. They did not see that a recession had begun in December 2007. They were caught flat-footed.
Today, Bernanke faces what Greenspan called "the complexity of the interactions of asset markets and the economy." His two-part policy has been to double the monetary base and to swap liquid Treasury debt for toxic assets held by the banks. He has allowed the banks to keep these borrowed assets on the banks' books at face value, as if they belonged to the banks. He has not challenged the Financial Accounting Standards Board reversal of its mark-to-market rule (FAS 157) in the week it would have gone into effect: April 1, 2009.
Consumers have not understood this FED-sanctioned policy of keeping bad assets on the books at Treasury debt prices. Bernanke has said that banks must be more transparent. Meanwhile, the FED has covered the entire banking industry with a security blanket that keeps economic reality from intruding.
Consumers are therefore confident. For now.
California's unemployment rate in May hit 11.5%. The state will go technically bankrupt on July 1. It is about to have its bonds downgraded to junk status. There are no green shoots in California. There is the equivalent of dead brush in forest fire season. No one seems to care.
The World Bank estimates that the world economy will sink by 2.9% in 2009. How scientific! Not 3% — exactly 2.9%. This, from an outfit that predicted with equal scientific rigor in March that the world economy would fall by 1.7%. Last November, it predicted that the world economy would grow by .9% — not 1%.
Regular gasoline is selling for about $2.70 around the country, up from $1.95 in February. The cost of getting from here to there is rising rapidly.
Yet the consumer says he is confident. "No problem!"
The summer will bring more news about rising unemployment. There will be more foreclosures. The real estate market will continue to decline. By how much? No one knows.
But aren't there statistics on foreclosures? Yes, but nobody knows if they are accurate. The U.S. government relies on a private firm, RealtyTrac, for its information. States use different ways to assess foreclosures. In April, the number of foreclosures reported for Atlanta by the national press was half of what the published local legal notices said.
The Case-Shiller index of 20 cities will show that housing prices are still falling. Commercial real estate prices will fall as vacancies rise. There will be more closed banks. The FDIC's assets will go below $12 billion. Then $11 billion. Then . . . ?
All of this is obvious. The public ignores it. This is why consumer confidence is a bubble. It keeps rising, yet it is not supported by the facts that count, which are data on the state of the real estate industry in relation to the solvency of the banks.
Doug French is a former banker. It was his warning at a conference in November 2005 that persuaded me that the real estate market and the banks were jointly entwined and headed for a disaster. His recent article, "Dead Banks Walking," appeared on June 16. His assessment indicates that we are nowhere near the bottom for either real estate or the banking crisis.
Bankers, pressured to earn returns for shareholders and protected from bank runs by FDIC insurance, have over time lent not only more of their deposits but advanced the money for riskier projects. James Grant in a recent Grant's Interest Rate Observer reminisced about National City Bank, which back in 1954 had only lent out 41 percent of its deposits, with less than one percent of the portfolio being real-estate loans.
By the end of last year, the total loan-to-deposit ratio for all US banks and thrifts was 87 percent, and 60 percent of all loans were classified as real-estate secured.
The public has never heard of the loan-to-deposit ratio. That does not change the fact that the ratio is historically high, and way too much of it is tied up in real estate.
I keep thinking on Mr. T's threat, 27 years ago: "You're going down!" The question is this: Is Ben Bernanke Apollo Creed or Rocky Balboa?
Optimism is as optimism does.
The American consumer may be less pessimistic today than in March, but he has less money to spend. His outlook has not been confirmed by the labor market. Unemployment is rising.
Then which market will confirm his optimism? Housing? No. Auto sales? In the second half of the worst year in decades? People are going to rush out to buy a new car, when the new models are due in October? We'll see in October. But the industry needs sales now.
Where will the hoped-for deliverance come from? Not from private industry. Private industry must compete for capital with the Federal government. Lenders must supply the Treasury with about $85 billion in loans each week to roll over the existing debt and pay for this year's deficit. From China? China is spending money on commodities and domestic bailouts. From Japan? With trade down, its surplus is down. From Europe? It is in recession. Then where?
There is no economic recovery yet. There is only a reduction in the decline of the economy. Earnings are still falling. Mortgage rates have risen. There is no end in sight for the real estate contraction. The banks will be squeezed. State budgets are running large deficits. They do not have money to offer more unemployment benefits. They are facing over $120 billion in red ink in the fiscal year beginning on July 1.
Tax revenues are down. Expenditures are up. Debt is rising. Interest rates will follow. State and local bonds will be downgraded.
So, consumer confidence is a bubble market. Stay out of it.
June 24, 2009
Copyright © 2009 Gary North