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JUNE 26, 2006
Bubble, Bubble, Who's In Trouble? Worried investors are hunting for safe havens. But with so many bubbles about, it's anyone's guess which way to turn. Too many bubbles, too many potential busts -- that's what's confusing the global financial markets these days. Housing markets are sky-high from Boston to Shanghai. Stock prices in India and Russia have roughly doubled in two years, with emerging markets such as Turkey, Indonesia, and Argentina not far behind. Prices for copper, oil, and aluminum have enjoyed equally outsize gains. The factory and office construction boom in China continues in full swing, creating the potential for massive overcapacity. And then there's the Houdini of levitating currencies, the U.S. dollar, which many economists fear could tank at any moment because of massive trade deficits. 
In this world of bubbles, investors see central banks armed with giant pins they're prepared to use. The latest U.S. inflation numbers, released on June 13 and 14, came in stronger than economists expected, making it almost inevitable that the Federal Reserve will continue to raise rates. The Bank of Japan and the European Central Bank are tightening monetary policy as well, depriving markets of the low-cost capital that helped fuel the global booms. Traders have reacted since May 11 by bolting from most markets, from U.S. stocks to commodities, emerging markets to gold. "The days of cheap money are coming to an end, and a lot of investors are getting nervous," says Stephen Gallagher, chief U.S. economist at French investment bank Société Générale. But for ordinary investors and big institutions trying to place their bets, there's a big unanswered question: Which bubble or bubbles are going to pop and which ones will prove sustainable? Will the U.S. be hit the hardest, or China, or commodity markets? If housing prices plunge in the U.S., will the ensuing economic collapse be limited to the U.S. or spread worldwide? No one wants to guess wrong, since being stuck in a full-scale bust can wipe out years of gains. For example, the NASDAQ Composite Index lost three-quarters of its value from 2000 to 2002. In fact, one could argue that the single most important decision an investor can make is to get out of the way of a collapsing market. RADICAL DIVERSIFICATION Unfortunately, it's nearly impossible to divine which part of the global financial system will crack, if any. As former Fed Chairman Alan Greenspan said in a 2002 speech, it's "very difficult to definitively identify a bubble until after the fact -- that is, when its bursting confirmed its existence." He was speaking about the U.S. stock market boom of the '90s, but predicting busts is even more tricky in today's global economy. How, then, should investors deal with this fundamental uncertainty? One option is to withdraw money from any risky market and shift it into safe havens such as money market funds. That's certainly happening, with taxable money market funds up $61 billion, or 3.6%, in 2006 so far, according to Money Fund Report, an industry newsletter, compared with a decline in the same period in 2005. The other option might be called radical diversification: the aggressive spreading of investments across sectors and regions. It has the advantage of ensuring that if a bubble bursts in one market, it affects only a small portion of an investor's assets. What's strange is that the financial markets have a bad case of the jitters just when the fundamental economic picture looks better than ever. Economists at the International Monetary Fund recently raised their forecasts for global growth in 2006 from 4.3% to 4.9%. Their expectations for 2007 went up as well. And while many markets around the world have experienced impressive declines over the past month, most are still up over a longer time span. Japan's Nikkei is 25% higher than it was two years ago, despite having lost 15% since May 11. India is up 88% despite its recent 28% plunge. Russia is still up 125% over two years, even after a 26% slide. Still, if we learned anything in the boom and bust of the past decade, it's that the bottom can be further down than anyone expects. That has housing watchers nervous. A new study from econonomic consulting firm Global Insight Inc. and financial company National City Corp. estimates that 71 metro regions in the U.S. are "extremely overvalued." High Frequency Economics in Valhalla, N.Y., is predicting a recession starting in the first quarter of 2007, largely because of a slump in housing sales. "We see people just walking away from the market," says Carl B. Weisberg, chief economist at HFE. "This is enough to drag our economy down to a full halt by the end of the year." Worried investors seem to have factored in a bust in two shifts: First, housing sector stocks began tumbling earlier this year; now, the broader markets are falling -- a sign of growing fears that economic growth is about to slow down. Yet while housing markets have cooled from their torrid pace, there's no sign of a collapse. Similarly, the U.S. dollar has defied gravity far longer than experts expected. A new study from a team of economists led by Richard H. Clarida of Columbia University calculates that the U.S. current-account deficit, now almost 7% of GDP, is substantially above the 2%-to-3% level that should have triggered a large-scale dollar depreciation. Yet the greenback has stayed relatively strong against a broad basket of currencies, dropping by only 6% over the past two years. Big-time investors such as Warren Buffett and Bill Gross are betting that'll change. Should worried investors shift money out of dollars? Perhaps, but it's easy to imagine scenarios in which U.S. equities look relatively safe, compared with the alternatives. For example, the Chinese government could be forced to clamp down heavily on borrowing to avoid overheating. That could have the effect of stalling Chinese growth, which would also reduce the demand for commodities around the world. Or, investors could suddenly get worried about taking risks in small economies and recoil from them. There "could be a crisis somewhere, whether it's Turkey or India," says Joseph Quinlan, a market strategist for Bank of America. "Then there would be even further outflows from emerging markets. You would see a flight to quality." Still, not everyone is worried about problems in China or an emerging-market bust. Weinberg points out that China's enormous growth in exports to the U.S. hinges on increasing penetration of the U.S. market, which should continue even in a U.S. recession. And as long as China can keep growing, it can keep buying raw materials from other developing nations. If confusion reigns over all markets, one universally feared wild card is the role of hedge funds. With more than $1.25 trillion in assets, much of it deployed in derivatives and other exotic securities, hedge funds may be vulnerable if there are sharp and unexpected movements in prices. No one knows how big the danger might be, since the number of hedge funds has grown so rapidly in recent years. "If there are enough little guys, it's more difficult to control because it's not necessarily concentrated in one area where the Fed can intervene," says Gallagher. If hedge funds start going bust, the speed of capital flows could be breathtaking. Regulators and investors fear that a wipeout in one market or asset class could spread to the whole global financial system. "The normal degree of danger of a financial crisis is 15%," says Stan Shipley, managing director for short-term forecasting at International Strategy & Investment, an economic analysis firm in New York. "We would now put that much higher, over 25%." And then there's the possibility that there will be no bust at all. "The global economy will pass the resiliency test," says Edward E. Yardeni, chief investment strategist for Oak Associates Ltd. "I think everything's going to settle down." Here's hoping he's right.  By Michael Mandel, with Peter Coy in New York
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