Boom and Gloom

For the past several months, investors have been acting like it's 1999, the first year when the Dow crossed 10,000, and stocks took off in complete disregard for reality. Yet the atmosphere then and now couldn't be more different. Back then, stocks were frothier than real businesses, no doubt. But today, American job prospects are the worst in a generation, many state governments are near bankruptcy, consumer credit has all but dried up in the developed world--and global investors see all this as a good sign? It's tough to find an asset class that isn't up, often way up: since the March lows, the S&P has risen by 58 percent; the NASDAQ is up 67 percent. Emerging markets (as measured by the MSCI index) have soared 95 percent. Commodities of all kinds are rising, with crude oil up 132 percent from its February lows and gold hovering around record highs. Although rumblings over banking regulation in Washington last week triggered a dip in financial stocks, the very firms that caused the financial crisis are still leading the industry league standings, up an eye-popping 126 percent since March.

Where is Robert Shiller (the bestselling author of Irrational Exuberance) when you need him? In fact, the Yale professor, who accurately foretold the crash of 2001, has just finished tallying the latest Case-Shiller index of top U.S. housing markets, which shows that home prices fell 7.2 percent between December and April, before rising 5 percent between April and August. While historical gaps in data make it tough to track perfectly, Shiller believes we have just seen the sharpest turnaround in American house prices in a century. British and Australian markets are starting to swing up, too, and in many Asian cities, real estate is positively buoyant. How is it possible that home prices are going up again even as employment is going down in most parts of the world, wage growth is nonexistent, and public debt levels are reaching record highs? "We've just gotten very speculative in our behavior, and it's a change that will likely last. I'm inclined to say that we're seeing a new bubble," says Shiller.

Or, more accurately, an echo bubble. It's a term economists use to describe the smaller bubbles that follow on the heels of major ones, usually after the authorities helicopter in loads of cash to patch up the first round of damage, setting the stage for a second round of easy-money-driven speculation. The phenomenon has been observed throughout history, from the British railway bubble of 1830 to the Saudi stock bubble of 2005. Edward Chancellor, author of Devil Take the Hindmost: A History of Financial Speculation, says, "Echo bubbles tend to be smaller and fade away faster than the first bubble." On average, they reach about 30 to 40 percent of the size of the original before bursting and sending market values back down to where they should have been all along, wiping out the gains of the echo, but generally not dipping back to the previous low. That implies a Dow falling to 7000 or 8000.

While new bubbles tend to build on entirely new market fads, echo bubbles generally retrace old territory. It's no accident that today's biggest price spikes are in assets like commodities (which peaked in 2008) and emerging markets (late-2007 peak). "The story of endless global growth, now driven by China and other key emerging markets, is a dream that dies hard," notes Ruchir Sharma, head of emerging markets for Morgan Stanley Investment Management.

The dream ignores the fact that global markets have yet to recover full health after the near-fatal heart attack in credit markets last fall. "Too many investors are treating the financial crisis as though it were a flesh wound," notes PIMCO CEO Mohamed El-Erian. "It's not: the system has been shaken not at the periphery but at the core," he adds, the core being the U.S. financial system. El-Erian believes that as regulatory changes play out, investors will come to see U.S. bank stocks the way they see utilities: dull and slow, not hot and high-growth. The markets are on a "sugar high," he says, and are trading at levels that assume the U.S. recovery will continue unabated, and GDP growth will be in excess of 3 percent. Unfortunately, he adds, that fails to recognize that the recovery "reflects temporary and reversible factors," like the huge stimulus package and inventory rebuilding, rather than a healthy return of private-sector employment and investment. In this scenario, El-Erian says, the U.S. will be lucky to grow by 2 percent.

The reality is that no one can be sure when the private sector will return to health. A good chunk of the profit recently posted by major multinationals has been wrung from cost cutting rather than from new ideas and sales. Banks like Goldman Sachs have pocketed record gains in recent quarters in part because lucrative trading positions no longer attract as many big players, now that so many big players are dead. The risky plays that killed them are still legal because there's been no real cleanup of the world financial sector. Bankers are likely to rack up huge bonuses this year as a result of the echo bubbles, a ringing incentive to indulge the short-term thinking that everyone says is part of the problem. Trading in derivatives and other explosive assets is still largely unregulated, even as governments take on mind-boggling debts in order to shore up the financial systems those assets brought down. It's no secret who'll foot the bill for it all: private citizens and private business. As Nobel Prize-winning economist Vernon Smith puts it, "The Fed has reserved us all!"

These facts are hardly secret: they are well known to anyone who reads the mainstream financial press. Yet the craziness is back, following the familiar pattern of echo bubbles, which are now well documented both in the historical record and in economic lab experiments. In one recent study done by Smith, participants were asked to trade an imaginary security, of which the underlying real value was understood. The experimental traders started out underbidding the security but slowly bid it up into a bubble, which then burst. They were subsequently asked to trade the same security again, knowing full well what happened last time around. Nothing changed--except the velocity at which the bubble was created; it happened much faster in the second round. Only in the third round did some participants finally learn their lesson. "We think we can beat the crowd," says Smith with a laugh. "But we are the crowd." It's true not only for the little guy, but also for the world's most sophisticated investors. El-Erian attended a gathering of such people recently, and while the general sentiment about the state of the global economy was bearish, the market positions were decidedly bullish (PIMCO has been reducing risk in its own portfolio).