Thursday, January 2, 2014

Financial Bubbles Make Stock Investing Difficult

It used to be that the Federal Reserve would trigger recessions by "leaning against" rising inflation pressures, pressures caused by a "too hot" economy.   To combat inflation, rising fed funds rates (the shortest interest rate set by the Federal Reserve) would eventually trip the economy into a recession and, in turn, cause GDP and stock market earnings/prices to cascade lower for a time.  During those recessions, bond prices would rise with the anticipation of lowered interest rates. This is reason for the "classic" investment portfolio mix of  60% stocks and 40% treasury bonds---because of this inverse price action.

Tried and true methods to predict 'traditional' recessions exist and include the Fed Funds interest rate relative to longer term market rates and the ECRI Leading Economic indicators.  But the problem for investors now is that the last two recessions were caused by burst financial bubbles:  the Tech bubble in 2000 and the housing bubble/financial panic in 2008.  With inflation and interest rates currently low, it is almost certain that the next (3rd) recession will be caused by another burst bubble.   Burst bubbles and financial crises can occur suddenly with few warnings and can lead to large investment losses.

Investor's Current Predicament: We Live in a Bubble Economy Caused by Central Banks and Governments

Here's the recent history of financial market bubbles. You can see that our government and Federal Reserve have, in fact, created significant financial instability. This is ironic because the Federal reserve was created to reduce financial stability.   See my blog:  Booms and Busts Caused by Federal Reserve.

And here's how stock prices and earnings performed during the last two bubble-induced booms and busts.  Buy and hold works over decades-long timeframes, but you can see how unstable earnings and prices have been in the past 20 years.  Send a letter to thank Alan Greenspan and Ben Bernanke.

Predicting the source and timing of bursting bubbles is very difficult since government authorities (all over the world) have been able to avert further problems after the 2008/2009 crisis by taking unusual measures to "kick the can down the road." An economic depression is "trying" to happen to clean out financial excesses, but the authorities won't let it happen.  But happen it will.  The number of festering problems and debt have risen dramatically all over the world.

Where are the biggest festering financial bubbles in world?  In another way,  you could ask where are the highest chances of financial "accidents?"  It's easier to identify the risks, but extremely difficult to predict the timing of these financial "events" that can hurt your portfolio.

The Biggest Financial Bubbles in the World

Here's my list of bubbles, listed roughly by the estimated magnitude of the bubble (or event):
  1. Housing and property market bubbles in China and the rest of Asia (Thailand, Australia, Singapore, Hong Kong) are a big risk for financial instability there and everywhere. Property prices and debt has rocketed-up in all of these markets.  The Federal Reserve's QE program has also inadvertently fed these bubbles.  Also 'hot money' flows in Asia are again feeding bubbles in that region.  As in 2008, in the US, a financial crisis could erupt in Asia at any time.
  2. There easily could be another Asian currency/debt crisis caused by "hot money" flows suddenly reversing.  This caused the last crisis in Asia in 1997.  Federal Reserve tapering (removing it's bond-buying program) has already created financial instability in emerging bond markets and their currency markets.  This could create currency and financial crises in nearly all of the emerging markets.
  3. A banking crisis in China causing a recession there could easily have knock-on effects in other parts of Asia, commodity producers and the world.  In general, debt in China has soared in 5 years to levels typically associated with financial crises.  The 'shadow banking system' in China has exploded dramatically because it has been un-regulated.  Attempts to reduce this have already led to surges in inter-bank funding markets in the summer and in December 2013.  This is a "canary in a coal mine" if there ever was one. 
  4. Unexpectedly higher interest rates in the US or Japan could pop the Asian and emerging market debt markets---and triggering financial crisis from China to Brazil to Turkey and Indonesia.  Emerging stock markets are already depressed.  
  5. An "accident" in the Japanese bond market causing a currency crisis and recession there. The massive QE program there might roil their bond market and starts a loss of confidence there and in Asia.  It could have knock-on effects due to a reversal of "hot money" flows to other Asia economies like Thailand and Indonesia.  
  6. The re-emergence of the Euro crisis;  the election of a leader that causes one or more country to exit the currency union and roiling all financial markets.  There is a risk of violence in one of the southern European states could cause a sudden reversal of the barely contained political and financial order.
  7. A war between Japan and China in the South China Sea could erupt sending markets reeling.  See Ridiculous Chinese Claims in South China Sea.  There has been a recent escalation of tensions with Japan.  China has suddenly claimed an "exclusion zone" which includes the Senkaku islands claimed by Japan.  The US is bound by a treaty to protect Japan.  
  8. Iran going nuclear is the most dangerous change in the political landscape of them all.  It would be a huge disaster for the West and cause other nations in that region to go nuclear as well.  Nobody should trust Iran's mullahs, but the Obama administration idiots are chasing some kind of political "win" for appearance sake with the Iranian idiots. 
"Accelerants" that could help propagate a financial accident into a financial "chain reaction." 
  1. The vastly expanded unregulated world-wide derivatives market.  It might not cause a financial panic, but it has the potential to worsen it. The problem?  No one knows how dangerous it is.
  2. Vastly expanded worldwide debt levels is much worse even compared to the 2008 debt crisis--especially in China and other Asian countries.   Higher debt=more instability.  By some estimates, world-wide debt has surged 40% to 100 Trillion since the last crisis.
  3. the exhaustion of policy tools of fiscal and monetary policy all over the world has added risk to the world economy.  If there are no policy tools left to counter-act the next financial shock, then there is a risk of prolonged depression.
Welcome to the most dangerous investment environment ever.  Be careful out there.  

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