Friday, April 28, 2017

The Bubble Economy Could Put Your Wealth At Risk

bubble economy
The world has been through a series of bubbles since the late 1990s and early 2000s. It started with the Dot-com bubble - a bubble characterized by rapidly inflating technology stocks as a result of the mania around the profitability of the internet. Then we got the housing bubble, fuelled by low interest rates of Ben Bernanke and Alan Greenspan as well as the government’s policy of increasing home ownership. When that bubble crashed, it nearly brought down the entire world economy and put us all into a new Great Depression.

Now some economists think that there’s a new bubble brewing - and this time it’s across the board. Bubbles tend to inflate when the market’s valuation of an asset is unrealistic. In the short term, it seems as if an asset is going to keep on going up in price and investors continue to invest. But in the long run, it always ends badly, and people wind up going broke. During the financial upswing of the last decade before the collapse of Lehman Brothers, investors all believed that the value of housing was going to go up forever. As a result, they lent out vast sums of money to homeowners, using their homes as collateral. Even if they couldn’t afford to make the monthly repayments it didn’t matter: house prices would continue to rise and the bank could simply sell the house to get its money back. Of course, the expectation that house prices would continue rising forever was incorrect. But banks and investors behaved as if they would go up and up regardless.

It’s worth considering for a moment why the last bubble blew up and why we might be in the middle of a new one. The last bubble in the housing market inflated because homeowners were incentivised to buy homes that they couldn’t afford. Low-interest rates ironically made homes less affordable since people were able to take on more debt. When the banks realized that homes weren’t as valuable as they thought they were, they demanded their money back and jacked up the interest rate. This led to a cascade of mortgage repayment defaults and caused bank balance sheets to collapse.

The reason that so many people were plowing their money into the housing market had to do with low-interest rates. Not only did low-interest rates make loans more attractive, but it also made investing in assets besides government bonds and savings accounts more attractive. The price of other assets was, therefore, bid up by investors looking for positive rates of return on their investments.

This sort of behavior is what causes assets to be overvalued. People aren’t investing in them because they are inherently valuable to society and the economy. They’re investing in them because they can’t do anything else to preserve their wealth. They’re forced to dump their money into stocks and other assets, like housing, because these are the only assets generating returns.

We see the effects of this all over the place. The stock market is hitting record highs, partly because of Donald Trump, but partly because people can’t put their money anywhere else. Generally, stock prices only rise if the profitability of the underlying firms goes up. Investors only get paid dividends if companies make greater profits. But this isn’t what is happening in the present situation. Stock prices are going up because the alternatives are so lackluster. And since there is nothing fundamentally driving the rise in stock prices, that’s a worry.

House prices are rocketing too. In fact, the ratio of house prices to income is reaching the same record highs as it did before the financial crisis. With record low-interest rates and continuing policies by the government to expand universal home ownership, prices in cities like San Francisco have hit new highs.

What all this essentially means is that we’re in another bubble. And, ultimately, all bubbles must pop, no matter how much the government or the central bank interferes. Ultimately, markets are the best placed to determine whether or not an asset is overvalued and they’ll react quickly if they think they are.

The question for investors is where to invest in the bubble economy? Long-term investors have few options it seems since so many asset prices are on the rise. The trick to investing in the bubble economy is to find assets that are undervalued relative to those that are overvalued.

Bubble Investment #1: Land

Land has always been a stalwart of investment. In fact, in the middle ages, your wealth was directly correlated with the amount of land you owned. The more land you had, the more peasants you could hire and the more surplus you could extract and sell to the market. In the modern world, the uses of land have changed somewhat. Land in areas ripe for development could be extremely valuable, especially in regions outside of expanding cities. Look out for land for sale in up and coming areas and make strategic investments. Unlike stocks or bond, the value of land cannot ever be completely wiped out, making it a great option when the economy is headed for a crisis.

Bubble Investment #2: Hard Assets

When Donald Trump was on the campaign trail, he warned on several occasions that the stock market was in a bubble. Like many other informed people, he knew that the fundamental performance of many companies simply wasn’t good enough to justify their sky-high valuations. As a result, he warned crowds at his rallies that there was going to be a correction. Since taking office, he’s taken ownership of the behavior of the stock market, saying that the rally is the result of the newfound optimism of businesses following his presidency. Of course, Trump doesn’t really know what’s causing the current bull market: the likely answer is that it’s a combination of both.

But what seems certain is that at some point investors will realize that the value of assets in the stock market is not materializing. And when they do, they’ll start selling stocks and buying up other physical assets, like housing, commodities, and gold. In fact, this is exactly what happened in the aftermath of the 2008 financial crisis. Investors realized that the value of stocks was going to plummet (thanks to the worsening economic outlook) and so they started buying up commodities and hard assets. This caused the price of hard assets to spike, rewarding those investors who’d gotten into the market early.

Bubble Investment #3: Should You Buy Bonds?

In normal times, government bonds are seen as the risk-free asset. No matter what, you’ll get paid. But since the financial crisis, we haven’t been living in normal times. Government debt has surged beyond all expectations, and interest rates have stayed near rock bottom. For investors, this is a problem. Bonds are risky, but the incredibly low yields mean that they’re not being compensated for all this risk.

Governments are effectively insolvent. The value of their taxpayers is actually less than the value of their liabilities. The owe more people money that they are owed. Mathematically, the current situation can’t continue. Either taxes are going to have to go through the roof which will kill economic activity, or people who have been promised money will have to take a haircut. For bond holders, both of these prospects are bad news because it means that the government might not be able to fund all its borrowing. And that is a good reason to want to avoid buying bonds.

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