Biggs on the New Normal

There are two mighty pillars of conventional wisdom that dominate the investment universe right now. The first is that the world's asset markets are insane and dangerously bubble-prone. The second is that the global economy is doomed to Pimco CEO Bill Gross's vision of a "new normal" of economic stagnation. This overwhelming consensus, this massive groupthink, arouses an instinctive reflex reaction in a contrarian like yours truly. The herd, we contrarians maintain, whether it is made up of wildebeests or investors, is almost always wrong. Keynes said it best: "The central principle of investment is to go contrary to the general opinion." When the crowd sagely nods its head when you pontificate about where the world is going, that warm sense of confidence you get is invariably the body temperature at the center of the herd as it thunders toward a cliff.

As everyone now knows, the world has become bubble- prone because Alan Greenspan and his acolyte Ben Bernanke are the greatest bubble blowers of all time. Green-span, after getting his head handed to him with a premature "irrational exuberance" call, ordained that it was not the job of central banks to pop bubbles. Now manic speculators rule the financial markets, and volatility and madness are the order of the day. Hedge-fund managers sit around salivating for the next bubble to sell short. They are convinced the two big bubbles swollen with highly flammable gas are emerging-market equities (particularly Chinese shares) and U.S. Treasury bonds. My guess is that they are several years early on both, and being early is the same as being wrong.

As for the new normal, its advocates argue that we have to pay for our sins of greed and leverage, and therefore we are in for a long, drawn-out, and very painful cycle of debt liquidation and sluggish GDP growth. The total return from equities will be meager and volatile, whereas well-managed bond portfolios will provide stable, mid- to high single-digit numbers that you can sleep soundly with. I have to concede that Gross, who runs the world's biggest bond-management firm, has history on his side. After a financial panic, there is usually a big rally that recovers about half the decline and then a long spell of equity-market meandering. The 1970s are a perfect example. But if investing were only about history, all the historians would be rich.

The prudent contrarian has to consider alternative outlooks. First, because everyone is so focused on bubbles, this obsession makes it much more difficult to inflate a big one. Emerging-market equities have done well this year, but they are still 30 percent below their highs of 2007. As for the alleged bubble in Treasury bonds, admittedly they have been wonderful long-term havens for many years, foreign holdings are enormous, and issuance will probably average $400 billion a year from now through 2012. However, foreign central banks will buy almost $500 billion this year, and U.S. commercial banks, still loan-shy, continue to pour money into Treasuries, which are decent value with 3.5 percent yield and inflation at 1 to 2 percent. These two "bubbles" are still just pleasingly plump.

While the new normal may satisfy our puritan instinct, I sense something wrong in the equation. It's possible that world growth—fueled by the rising share of world GDP (now 36 percent) derived from the developing economies, or from some surge in new green or energy technologies—will turn out to be far better than what Gross & Co. envision. Stranger things have happened in the past. In 1947 the world seemed very grim indeed, and yet it was on the verge of the greatest boom in history. Warren Buffett recently pointed out that stocks usually did best when the economy was at its worst. On the other hand, it's also conceivable that the new normal is too benign. The doomsayers are right. The global economy double-dips as commercial real estate collapses and banks are crippled. With the authorities having already used most of their stimulus ammunition, there is not much they can do. Unemployment continues to rise, corporate earnings collapse, residential house prices fall again, and stock markets go to new lows with disastrous wealth effects. That worst-case scenario may be worth betting on too. Just don't run with the middling crowd.