Is The Next Bubble Unavoidable?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Before I discuss my latest topic, a follow-up note on my last comment on private equity.
I spoke with a senior private equity pension fund manager this morning
(great guy who really knows his stuff) and he told me the secondary
funds are not doing as well as you'd think.

I was surprised
given that many endowments, pension funds and insurance companies are
looking to unload some private equity stakes. He told me that the
"bid-ask spread in the secondary market is too high". He was waiting
for some correction in the markets to see if they come in.

He
also told me that the days of loading up debt to the max are over.
"More and more private equity deals are being done with a lot less
leverage." He added "there is no more rising tide" to reward you for
taking on leverage.

According to him, many GPs are scared to
death that LPs will not be able to meet their capital calls. I told him
that private equity is better than real estate, but it will take some
time before it recovers.

One thing that scares him (and me) is
the influx of sovereign wealth money from China and other places coming
into private equity. If they start bidding deals up then valuations will
get all out of whack.

That gets me into my latest topic. On Monday, the first rate hike marked a shift, igniting markets:

Australia
broke ranks with other industrial economies Tuesday in a policy
reversal that sets the stage for other central banks to follow suit, as
they, too, become more concerned with preventing an outbreak of
inflation than propelling economies out of recession.

The
Reserve Bank of Australia boosted its key lending rate by a quarter of
a percentage point to 3.25 per cent, and Governor Glenn Stevens
signalled that further hikes could follow.

The move reverses a
series of sharp cuts made in the wake of the collapse of Lehman
Brothers last September and the ensuing credit crunch that slammed
strong and weak economies alike and brought international trade,
Australia's lifeblood, to a near standstill.

The
central bank's unexpected move was widely viewed in the markets as a
confirmation that the global economy is on the mend. Investors rushed
into the Australian dollar and other commodity-based currencies,
including the loonie.

Gold climbed to a record $1,043.20 (U.S.)
an ounce and the U.S. dollar plunged, as less-fearful investors rowed
away from what they had considered a safe harbour in uncertain waters.

The
key question now is whether other central bankers looking at
stabilizing employment and brightening growth prospects will similarly
move to reverse historically loose monetary policies.

Rumors
are that Norway's central bank will also raise rates. But there is no
chance that the Fed or the Bank of Canada will raise rates anytime
soon. The Canadian dollar surged following the Australian rate hike and Bank fo Canada has already repeatedly expressed its concern over the rising loonie.

As
for the Fed, they're in no hurry to lift the fed-funds rate. With the
US dollar depreciating and interest rates next to zero, financial
conditions remain very accomodative. In my opinion, the Fed will wait
to see unemployment falling a full percentage point before considering
raising the key rate. And that won't happen until mid 2010 at the
earliest.

Of course, growth could surprise to the upside,
especially in a V-shaped recovery, and that will force central banks
around the world to carefully coordinate the gradual withdrawal of all
that stimulus.

In the meantime, stock markets will continue to
grind higher. I have seen this all before. Stocks typically surge at
the initial rate hikes as they see this as confirmation of global
economic recovery. Will it go parabolic from here? Who knows?

Reporting for the Business Insider, John Carney writes Is The Next Bubble Unavoidable?:

The
Federal Reserve is now faced with a challenge that is akin to threading
a needle by throwing a spool of thread across a football field.

It
is attempting to keep loose money and quantitative easing policies in
place long enough not to stymie the nascent recovery while pulling them
back in time to avoid massive inflation. It's a Hail Mary pass with an
impossibly small target while facing a blitz.

In today's Wall Street Journal, Nouriel Roubini and Ian Bremmer lay out a series of policy prescriptions
for how they think the Fed might be able to avoid creating another
dangerous asset bubble without triggering a double-dip recession. They
are very clear that this is an enormously difficult task--but even
their assessment might be too optimistic.

Here's the problem.
They agree that the operations of the Federal Reserve need to be
subject to political review because it is clear that the New York Fed
has been captured by Wall Street. The Fed's worries about its
independence being compromised make no sense when it seems that its
independence is already compromised to the our powerful financial firms.

But
Congressional oversight is likely to result in pressure to keep
monetary policy too loose for too long. Pulling back on easy money when
the financial system recovers but the real economy is still shaky, will
elicit howls of protests from politicians whose constituents are still
out of work, loosing their homes and seeing their credit lines closed.
There will be intense political pressure to repeat the "fateful
mistake" of the last recession, keeping monetary policy too easy for
too long.

Roubini and Bremmer's way out of this trap is to
recommend better supervision of banks, including the creating of a new
insolvency regime for the most important financial institutions and
better capital requirements. This too is harder than it looks.
Politicians, especially in Europe, are more attracted to regulating
banks through regulating pay than the complex and costly job of
reforming capital requirements. And policies that regulate 'too big to
fail' institutions run the risk of creating the impression of a
government guarantee.

Is there are way out? Unfortunately, the
way out may be the way back. The government, including the Fed, need to
restore the credibility of market processes by letting a too big to
fail institution go insolvent. In short, we need another Lehman. And a
policy that depends on failure to succeed is certainly not a happy one.

I quote the following from Ian Bremmer's and Nouriel Roubini's article in the WSJ, How the Fed Can Avoid the Next Bubble:

As
for the exit from monetary easing, the Fed must learn from the fateful
mistake it made after the 2001 recession. Then, the central bank cut
the federal-funds rate too much and kept it too low for too long. It
also moved far too slowly when the normalization occurred—in small
increments of 0.25% from summer 2004 until the summer of 2006, when it
peaked at 5.25%. Normalization took two full years. It was in that
period of slow normalization that the housing, mortgage and credit
bubbles spiraled out of control. The lesson learned: When you
normalize, move rapidly, or prepare for another dangerous bubble.

Of
course, this is easier said than done. From 2002 to 2006, the Fed moved
slowly because the recovery appeared anemic and because of significant
deflationary pressures. This time around, the recession is more
severe—unemployment is at 9.8% and is expected to peak above 10%, and
we are experiencing actual deflation. Therefore, the incentive not to
exit too soon will be greater and the risk of creating another bubble
is greater. Indeed, the sharp increase in the stock market and
commodities, and narrowing of credit spreads since March, are partly
due to a wall of global liquidity chasing assets and already causing
asset inflation.

If the conflict between economic growth and
financial stability requires that monetary policy remain loose, then it
is critical that the supervisors and regulators of the banking sector
move aggressively to prevent another bubble from emerging. Thus they
should quickly adopt the regulatory reforms agreed to by the
G-20—including a new insolvency regime for financial institutions
deemed "too big to fail," a serious approach to limiting "systemic
risk," and appropriate rules governing incentives and compensation for
bankers and traders.

Good luck. I see more bubble trouble on the way. Risk assets are being bid up all over the world as investors look for higher yields. I already spoke about overheating in Brazil but another stock market bubble is happening in India (hat tip Fred):

India’s
stock market recovery over the last six months is a bit too remarkable
for comfort. From its March 9, 2009 level of 8,160, the Sensex at
closing soared and nearly doubled to touch 16,184 on September 9, 2009.
This is still (thankfully) well below the 20,870 peak the index closed
at on September 1 2008, but is high enough to cheer the traders and
rapid enough to encourage a speculative rush.

There are two noteworthy features of the close to one hundred per cent
increase the index has registered in recent months. First, it occurs
when the aftermath of the global crisis is still with us and the search
for “green shoots and leaves” of recovery in the real economy is still
on. Real fundamentals do not seem to warrant this remarkable recovery.
Second, the speed with which this 100-percent rise has been delivered
is dramatic even when compared with the boom years that preceded the
2008-09 crisis.

The last time the Sensex moved between exactly similar
positions it took a year and ten months to rise from the 8,000-plus
level in early 2005 to the 16,000-plus level in late 2007. This time
around it has traversed the same distance in just six months.

Forget
fundamentals. Hedge fund flows, investment banking flows, sovereign
wealth fund flows, pension flows, and retail speculation will drive equities and other risk assets much
higher. How long can it last? Remember the famous quote from John
Maynard Keynes: "The market can stay irrational longer than you can
stay solvent."

Comments

[DBLTapViper]

Leo, Thanks for your insight, one question,  how does/could it all go wrong and deflation wins?

DBL

[Anonymous]

...And the crash when this all comes apart in a
year or two because we kicked the can down the road
(yet again) is going to make last year's troubles look
minor in comparison. Terrific.

Stocks will go to the moon, but Sunoco has to idle
a refinery and cut their dividend in half
because gas isn't selling. What terrific
fundamentals we have under this. I'm curious -
if we do have sizable inflation - how companies
will be able (at least in the US) to pass off
those increased input/commodity costs.

I feel like the Jim Rogers scenario - stocks to
crazy levels, only because of so much money
being thrown at the market, not because of any
fundamental improvement. Nike near all time highs
during this time period? Yeah, right.

[bonddude]

Yes, he reconfirmed buys today w/Maria Buttercup. "Wouldn't buy today but gold, commodities, ag. will be much higher..." long term.

[Green Sharts]

A tsunami of liquidity is heading our way and you'll see it in high beta stocks, emerging market stocks and bonds, commodities, commodity stocks, commodity currencies, high yield bonds, etc.

Heading our way?  You'll see it?  Maybe you haven't noticed that every one of those categories you cite have had explosive rallies in the last 6 months.  Junk bond spreads have dropped from over 2000 basis points over treasuries to less than 800 and now you tell us a tsunami of liquidity is going to cause junk bonds to rally.  Thanks for the heads up.

This liquidity driven rally will last a lot longer than most skeptics think.

Blah blah blah.  This rally may top out today and it may go on for another year.  You have no idea and neither does anybody else.  When markets detach from the underlying fundamentals they can go anywhere in the near term.

Your columns are absolute drivel.  I have no idea why ZH gives you a forum for them.

[Anonymous]

I liked it

[Anonymous]

GS, what is your point?

[estaog]

^{You have no idea and neither does anybody else.}

So what are we doing here exactly?

[Anonymous]

If they let the bubble continue, they are
idiots as prices are already 50% above
reality based on historical multiples.
If Rahm and Summers want to ramp something,
maybe they try the US dollar.

[tradeking13]

Let me know what pensions you manage or advise so I can avoid them like the plague.

[Anonymous]

Wow. 7 months ago we were going back to the barter system and now we are going to the moon. This market scares me and I want no part of it anymore. It is completely uninvestable at this point. It has become a casino -- a rigged one at that. Good luck and goodbye.