October 3, 2016

Sizing Up the Bubble

John P. Hussman, Ph.D.

Greater fools

Every financial bubble rests on the presumption that there is still some greater fool available to purchase overvalued assets, no matter how overvalued they might become. 

In the recent half cycle, central banks have intentionally extended this speculation by promising that they, themselves, could be relied upon to be those greater fools. Yet despite the most extreme version of these assurances in Japan, where the Bank of Japan has driven long-term interest rates to negative levels and has purchased stocks outright, the Nikkei 225 index is no higher than it was in November 2014. Indeed, the Nikkei is no higher than it was 30 years ago, having lost more than -60% of its value on three separate occasions, two of them in a period when interest rates were pegged at zero, and never rose above 1%. Investors have been lulled into believing that an endless horizon of weak growth, easy money, and zero interest rates is desirable, when it is actually a syndrome of flat-lining vital signs. 

What will drive the next crisis is not some rate hike by central banks (whose activist interventions have essentially zero correlation with subsequent real economic outcomes). 

Instead, the collapse will emerge both naturally and inevitably, as the progression of the economic cycle takes its course, and investor preferences shift from risk-seeking to risk-aversion. 

Virtually any commonplace shock is now capable of being a pin-wielding butterfly on this increasingly vulnerable financial bubble. 

"Debt defaults, insolvencies, and pension crises are already unavoidable." 

Year-over year growth in real GDP, real gross domestic income, durable goods orders, real retail sales, industrial production and other measures are all down to levels typically observed at the beginning of recessions. We won’t pound the tables about imminent recession until we observe fresh weakness in the equity market (even a 7-8% market loss would sharply raise our probability estimates), but it’s important to recognize that financial risks are already fully developed, and as in other bubbles, one usually finds “catalysts” to blame for a collapse only well after the downturn is in full-swing.

DYI