How you can survive the new bubble economy

By MoneyWeek Editor John Stepek Nov 12, 2009

John Stepek

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A debate is raging in the financial world. Are cheap money policies fuelling a bubble in asset prices or not?

I'm not sure what all the fuss is about. The answer's obvious. Of course most asset prices are at, or heading for, bubble levels. Oil's near $80 a barrel even although there are ship-loads of it just floating around, being stored at sea. Most stock markets are overpriced in historical terms. Bond yields are at record lows.

The real question for investors is – are any asset prices justified at current levels? And if so, which ones?

Cheap money policies are inflating asset prices around the world. This seems self-evident. For one thing, everything is going up. Stocks, bonds, gold, oil, base metals – it doesn't matter. Assets that shouldn't really be correlated are all heading up together.

Now that might just be a sign that no one knows what's going on, so the big bets aren't being placed on any single asset class. And judging from the wide range of diverse opinions I'm reading and hearing from fund managers, investment 'gurus' and other journalists, I'd say that's probably a fair comment. But it's also a clear sign that there's too much money flowing into the financial system.

The clearest sign we're in a bubble

Probably the best sign that we're in a bubble is this: all the people who are saying that this isn't a new bubble are the same ones who said that the credit crunch couldn't happen. Take former member of the Federal Reserve board of governors, Frederic Mishkin. In a piece for the Financial Times this week, he argued that there probably isn't a bubble, and even if there is, it isn't dangerous enough to warrant the Fed tightening monetary policy to prevent it from growing any further.

It's a variation on the same old drivel that got us into this mess in the first place. It's hard to spot bubbles, he says: "asset-price bubbles… are hard to identify; after the fact is easy, but beforehand is not". Mishkin also argues that if you tighten monetary policy to "restrain a bubble that does not materialise" then you get "much weaker economic growth than is warranted." Piously, he adds: "Monetary policymakers, just like doctors, need to take a Hippocratic Oath to 'do no harm.'"

This last comment gives an interesting insight into how central bankers think. If your idea of 'doing no harm' is to pump a patient full of adrenalin every time they catch a cold, then perhaps this metaphor makes sense. But of course, over-stimulating an economy is just as dangerous as under-stimulating it. And our experience of the past 25 years of serial bubble-blowing should surely have taught us that by now.

In any case, as Edward Chancellor of GMO points out in a letter to the FT this morning, Mishkin's words are worth taking with a big pinch of salt. Back in January 2007, he also said that falling home prices were "unlikely to produce financial instability."

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So on the one hand, the bubble blowers are still pleading ignorance. On the other side of the debate, you have intelligent successful investors such as Marc Faber of the Gloom, Boom and Doom report, who argues that: "when interest rates are near zero, and when central banks print money, the existing and newly created liquidity will flow somewhere. And given the enormous excess capacities that plague the manufacturing sector, these excessive liquidities won't flow into investments in plant and equipment and translate into the employment of more workers, but will flow into asset markets and boost their prices."

What this means for investors

What does all this mean for you as an investor? First things first, it's hard to trust markets when their health is based primarily on the actions of central banks and governments. That's one reason why we prefer to keep an eye on the fundamentals rather than taking punts on how big the next phase of quantitative easing might be.

So as we keep saying, defensive stocks, paying decent dividends, still look good. They might not rocket like more speculative plays, but you also don't have to keep one eye on the Bank of England all the time. On top of that, you get a decent income. And better yet, if stock prices keep rising, you'll get the benefit from that too.

Emerging and Asian markets are also worth having exposure to. My colleague Cris Sholto Heaton writes about these regularly in his weekly free email 'MoneyWeek Asia' (if haven't done so already, sign up to MoneyWeek Asia here). For one thing, these economies look healthier in the long run than over-indebted Western ones. And for another, these markets are likely to attract a lot more of that cheap money flowing around the world just looking for a home.

Gold's bull run is set to continue

And then of course, there's gold. It's at a record high (in US dollar terms at least) and so people are getting worried that it's in a bubble. But gold is probably among the few assets whose current valuation makes perfect sense. It's the closest thing we have to a fixed point in the financial system. If you imagine that gold, over the very long term (and I really am talking about decades and centuries here), essentially maintains its purchasing power, then you can use it as a barometer of how over or undervalued everything else is. Its price is soaring because by comparison, the value and credibility of paper money is in sharp decline.

And until central banks decide that paper money is worth defending, gold's bull run is set to continue. Our regular commodities correspondent Dominic Frisby talks more about gold (and throws in some mining tips) in this week's issue of MoneyWeek magazine, out on Friday (if you're not already a subscriber, you can claim your first three issues free here).

Our recommended article for today

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Biotech is a notoriously tricky sector to invest in. But find the right company and you could make huge profits. Here, Louis Basenese picks two small-cap stocks that he thinks could be set to soar.

Comments (10)

Published in Economics | More articles by John Stepek

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  • 1. rik

    (12 November 2009, 11:35AM)  Complain about this comment

    You were very kind on Mishkin. You left out his analysis of Iceland's economy from 2006 in which he argued that Iceland had a very stable economy and there was no reason to worry about their levels of foreign debt.... As an economist this evidently idiotic analysis apparently did not dent his career. After all, he is no worse than the rest of them.

  • 2. mad terrier

    (12 November 2009, 12:06PM)  Complain about this comment

    Your views on where to invest now - Asia, gold and defensive stocks are consistent with what you've been saying for a while. But you didn't mention corporate bonds, which up until now have been one of your FOUR preferred asset classes. Does that reflect that you think they have had their day in the sun? Some yields on corporate bond funds still look good in a low interest rate environment, but perhaps are not as good as defensive stocks now, especially with fund manager charges deducted.

  • 3. Alex

    (12 November 2009, 02:24PM)  Complain about this comment

    What is stunning about the current bubble as opposed to the one created in say 2002....is that whilst the commodities and stock markets are booming, out in the real world wages are being frozen, unemployment is hitting multi decade highs and real incomes are falling. Any vestige of a correlation between the world of Wall Steet and Main Street seems to have gone. Something similar happened in France once upon a time, the result for the rich wasn't a happy one.

  • 4. Roger

    (12 November 2009, 03:49PM)  Complain about this comment

    Everyone was saying that economics was no good, unemployment is rising, do you drive to work at peak hours? They are back to 2007 levels. Do you go have a walk around town in the evening? All the restaurants are busy. Recession? Are you talking about pre-August 2009 ?

  • 5. Alex

    (12 November 2009, 04:52PM)  Complain about this comment

    What Recession? Youth unemployment in the UK is running at 20%, total unemployment ( even after massive massaging of the figures ) is almost at 2.5m, and we've had the longest economic contraction of record.

    I'm sure that those people still in work are still driving to work, lets face it they don't have much choice in the matter, but that doesn't mean that there disposable income isn't being squeezed, most private sector firms are freezing wages and low inflation won't last long.

    Restaurents may be busy in the Square Mile and West End...but bankers and torists are hardly representative of the country as a whole. No restaurenteurs or landlords I know are talking about business booming that's for sure.

  • 6. Brian

    (12 November 2009, 04:59PM)  Complain about this comment

    Unemployment when the real figures come out will surely halt any bubble or mini boom. How about a review of the figures and what can already be addedto those figures given BT, BA and others already stating that they are planning large cutbacks. What about government employees will we see some fallout there as well? Are the current government concealing all the bad news until after the election and where has any vestage of honesty gone. I am beginning to think that politics stinks when you look at the ride Mr & Mrs Kinnock have had in the EU and Tony Blair and the delightful Cherie appear to be bagging unheard of amounts of money. By the way I read somewhere that there are now 2 Blair charities does he or she take any income from these sources as well. Greed is ruining any chance we have of a decent society when this mess is finally sorted out we need a sea change in attitude at the very top.

  • 7. rik

    (12 November 2009, 06:44PM)  Complain about this comment

    You were very kind on Mishkin. You left out his analysis of Iceland's economy from 2006 in which he argued that Iceland had a very stable economy and there was no reason to worry about their levels of foreign debt.... As an economist this evidently idiotic analysis apparently did not dent his career. After all, he is no worse than the rest of them.

  • 8. Miles

    (12 November 2009, 07:36PM)  Complain about this comment

    Gold is a commodity that always does well in times of panic and market turmoil. You need only look to recent announcements by governments and central banks across the world, including India, China, Russia and others, who have all indicated that they will be acquiring more gold in their portfolios.

    Ultimately, as your article alluded to, it is events that are shaping the price of gold and where it goes from here.

    http://goldpricetoday.co.uk/archive/events-shaping-gold-price-and-mining-65469

  • 9. Mark M

    (13 November 2009, 10:25AM)  Complain about this comment

    Isn't the high unemployment we still have despite signs of recovery in the financial markets merely the lag we always get when the economy starts to pick up? Even supporters of the govts policies of the last year or so were saying a while back that they didn't expect unemployment to fall in the initial stages of the recover since companies would be restructuring and recovering from the recession themselves. Then gradually, as things improve for companies, so they will start to take on staff.

    All I am asking is: is this recovry really ferent from previous ones? Wouldn't we naturally expect the financial markets to pick up first, then companies and then finally unemployment will start to fall? If not, then what is different this time?

  • 10. Shane

    (16 November 2009, 10:36PM)  Complain about this comment

    Mark, you are right and most people only look in the rear view mirror. "Will the market peak soon" is a good article, as is the one about defensive stocks. Stocks often rise on bad news and fall on good news. The reason for this is because when the good news comes out it has already been anticipated into the price of the stock. Is this recovery different from previous ones? Which previous ones? I studied all the major equities crashes in Australia since the late 1880s and many in the UK and US. The markets have already picked up about a 50% retrace. This is common the first year after a bottom, and it may go higher, even to a full retrace. However, in almost all situations the market either gave up most of those gains or crashed again. Investing now depends on the duration of your investment. The fate of the US dollar and hence the capacity of low US interest rates is a big question mark . The carry trade is becoming a howling wind that cannot be ignored.

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