Friday, April 27, 2007

The First Global Bubble

26 April 2007

Jeremy Grantham is one of our most respected global investment advisors. On April 24, 2007, Mr. Grantham published a groundbreaking article suggesting that, for the first time in the history of our planet, a global investment bubble has emerged.

You can follow the links above to learn more. However, a reader on Bill Fleckenstein's website has summarized Mr. Grantham's article for your convenience. What follows are a few excerpts and Mr. Grantham's summary:

It's Everywhere, In Everything: The First Truly Global Bubble

The necessary conditions for a bubble to form are quite simple and number only two. First, the fundamental economic conditions must look at least excellent - and near perfect is better. Second, liquidity must be generous in quantity and price: it must be easy and cheap to leverage....That these two conditions have been met now hardly needs statistical support, so widely accepted have they become.

Never before have all emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere - emerging or developed - out of 42 listed by The Economist grew its GDP by less than Switzerland's 2.2%!...

Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong "animal spirits," reflected statistically in a low risk premium.

Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take.......everyone, everywhere is reinforcing one another.

Wherever you travel you will hear it confirmed that "they don't make any more land," and that "with these growth rates and low interest rates, equity markets must keep rising," and "private equity will continue to drive the markets."

To say the least, there has never ever been anything like the uniformity of this reinforcement. The results seem quite predictable and consistent. All three major asset classes - real estate, stocks, and bonds - measure expensive compared with their histories and compared with replacement cost where it can be calculated.

The risk premium has reached a historic low everywhere...

So to recap and extend:

1. Global fundamental economic conditions are (perceived as) nearly perfect and have been for some time.

2. Availability of global credit is generous and cheap and has been for some time.

3. Animal spirits and optimism are therefore high and feed on themselves through reinforcing results and through being universally shared.

4. All global assets reflect this and are overpriced and show, probably for the first time, a negative return to risk taking.

5. The correlation in global economic fundamentals is at a new high, reflected in the steadily increasing correlation in asset price movements.

6. Global credit is more extended and more complicated than ever before so that no one is sure where all the increased risk has ended up.

7. Every bubble has always burst.

8. The bursting of the bubble will be across all countries and all assets, with the probable exception of high grade bonds. Risk premiums in particular will widen. Since no similar global event has occurred before, the stresses to the system are likely to be unexpected. All of this is likely to depress confidence and lower economic activity.

9. Naturally the Fed and Fed equivalents overseas will move to contain the economic damage as the Fed did last time after the 2000 break. But the heart of the last bubble, the NASDAQ and internet stocks, still declined by almost 80% and 90%, respectively. (The heart of the bubble this time is probably private equity. In 10 years, it may well be described as the private equity bubble just as 2000 is thought of as the internet bubble. You heard it here first!)

10. What is wrong with this logic? Something I hope.

11. Of course the tricky bit, as always, is timing. Most bubbles, like internet stocks and Japanese land, go through an exponential phase before breaking, usually short in time but dramatic in extent. My colleagues suggest that this global bubble has not yet had this phase and perhaps they are right. (A surge in money flowing into private equity might cause just such a hyperbolic phase.) In which case, pessimists or conservatives will take considerably more pain. Again?!


  1. Hmmm ... all I know is the TSX is up and we're happy about it, sounds like everybody's TSX is up.

  2. The investment world tends to move in large cycles. Because our central banks tend to print a lot of money and interest rates are low, there are a lot of people trying to figure out what to do with currencies that are declining in value relative to things that are real, such as natural gas, copper, cars and groceries. This environment encourages investment, and thus stock prices. Further, Canada is in the business of selling things that are real to the rest of the world, such as minerals and oil. That helps the TSX. The problem is that bubbles are fueled by debt, and at some point, people have to stop borrowing - though it's amazing to consider all the different ways you can get credit. However, when people either decide to start repaying their debts or are no longer allowed to borrow (bankruptcy can do that), then that creates a much weaker environment for general stocks and for currencies (as at some point the progress of inflation becomes recognized). At this point alternatives to "paper/digital" currencies become desirable, and that means gold and silver. Canadian Oil Sands Trust may continue to do well, even if the Ontario Teachers' Pension Fund buys it. But bank stocks and the stocks of retail companies, for example, may not look particularly attractive. When you divide stock prices by the value of gold, stocks have now fallen for 8 years, and that is a multi-decade trend. We may not be facing a global depression, due to the rise of the Asian economies, but things have already started changing. It has been going on for 8 years, and my take is that we are just getting started.