By James Corbett
Bubbles happen. This is a piece of hard-won economic wisdom fit for a bumper sticker. We have seen bubbles form in markets throughout history, from the famous tulip mania of the 17th century to the South Sea bubble of the 18th century to the stock bubble of the Roaring Twenties to the Japanese bubble of the 1980s. Inevitably they are caused by a perfect storm of economic conditions and market hype creating a feedback loop of rising prices and rising hysteria. Given their repeated appearance throughout history, and given human tendencies to get caught up in speculation and hype, it seems unlikely that we will ever be able to stop them forming entirely.
But in recent years, bubbles have taken on a new significance. It would not be exaggeration to say that the American economy has been running on bubbles for two decades now. The dotcom bubble of the 90s gave way to the housing bubble of the Bush era and now the Bond bubble of Chairman Ben's QE insanity. This is not an isolated occurrence of hysteria, but a prolonged period of financial illusion. As fast as one bubble deflates, a new one is inflated. It gives the impression of a steadily growing economy subject to the occasional setback, but in reality the economy is being supported by a string of carefully crafted fictions.
Sadly, as with every other fiction, the story has to end at some point. And when this era of bubble creation ends, vast swathes of the public stand to lose everything they have. That's why it's important to identify, understand and avoid the bubble trap. Because as hard as it is to believe, it's not always possible to see the bubble while you're inside of it. In fact, this is one of the ways that a bubble economy operates: by convincing you that this time it isn't a bubble at all, it's a “new normal” that's rewriting the laws of economics.
In that spirit, I offer you three of the bubbles of our present era, and the best way to position yourself for their inevitable popping.
Bubble 1: The Canadian Housing Bubble
Housing prices in Vancouver are a perennial complaint. Paying seven figures for over-glorified crack houses has never made sense except as an acknowledgement that this is the going price of land in the downtown Vancouver area. But sadly for Canadians, Vancouver isn't the only Canadian real estate market with inflated prices.
For confirmation that a downturn in housing will affect all Canadians, the inhabitants of the Great White North need only look to their neighbors to the south. During America's housing bubble, Alan “Bubbles” Greenspan assured the country that there was no national bubble, only a lot of local bubbles. He was wrong. Although prices fell hardest in a few especially overvalued markets (Sacramento, Miami, Phoenix, Las Vegas), the crash affected the entire country. The same phenomenon is shaping up to take place in Canada.
So, too, are there signs that Canada didn't avoid the American housing crash through sensible regulations and stable markets (as they like to brag), but have simply managed to postpone the moment when the piper asks for his dues by a few years. Look at the chart of housing prices to average income. The American chart shows an uptick in 2001 as the dotcom bubble burst and Bubbles Greenspan brought rates down to nothing to kick off the housing bubble. By 2006 the ratio was at an all-time high. The establishment talking heads assured the bubble-crazy public that this was a “new normal” (just as the dotcom bubble and Dow 40000 was a “new normal” until that bubble burst), but they were proven wrong when the bubble inevitably popped and kicked the Bear Stearns / Lehman Bros / AIG crisis into motion. But look at the Canadian chart. It tracks the American numbers for the most part through the gentle downturn and uptick in the 90s, and picks up in 2001 exactly in line with the US markets. But instead of crashing in 2006, the Canadian markets continued to tick up. After a slight correction in 2008, the numbers continued upward so that now the housing price to income ratio is sitting at or near all-time highs. This is a precarious situation, and does not at all reflect the fundamental soundness of the Canadian housing market.
In fact, the OECD released a report last month ranking Canada as the world's third most over-valued housing market. The Economist estimates that the housing market is overvalued by a whopping 73% compared to long-term rents. At the same time, household debt in the country has risen to a record high of 95% of GDP. This suggests that the sharp correction in Canada's housing market that economists are almost universally predicting will have a catastrophic effect on debt-saddled Canadians and, in turn, on Canada's much-ballyhooed bank credit system, so much lauded and touted for avoiding the turmoil that the 2006 crisis wreaked on the American banking sector.
So how can the average person position themselves to survive or even thrive as Canadian housing sales stall and the occupants of the bubble begin rushing for the exits? Well, for one, this is not a good time to be buying into the market. Even the most optimistic establishment talking heads are talking of the inevitability of a “soft landing” for the market. If history is any guide, that “soft landing” will be about as “soft” a landing as the one that passengers on the Asiana 777 felt last week in San Francisco. Hold off for now in the rental market and wait for the crash before buying up that property you have your eye on. It is also advisable to think of shorting the Canadian dollar as a bet that Canada's central bank will slash rates and start printing money like there's no tomorrow once the market crashes. As always, precious metals are a good hedge against the inevitable round of devaluation that follows the popping of all such bubbles.
Bubble 2: The Student Debt Bubble
Bubbles are usually the result of speculative hysteria about specific commodities or investments. But sometimes they are the result of delusional ideas about the long-term benefits of intangibles. Such is the case with the student debt bubble.
Last week in this column we were discussing the dangers of credit card debt and the need to dig yourself out from under it. In many ways, student loan debt is even worse. In fact, in 2011 total student loan debt in America passed $1 trillion, far outstripping total credit card debt of $850 billion. That's a significant number. But is it a bubble?
A bubble is what develops when an irrational exuberance over an investment combines with easy credit to create a steadily increasing overvaluation of that investment. This is exactly what happened in America with the housing bubble last decade, fueled by record low interest rates combined with exceptionally easy credit from the banks and an expectation that housing prices could only go up. This is exactly what has been happening with student loan debt for decades.
In the past, higher education was seen as a stepping stone to white collar work, job security, and higher earnings potential. As a greater and greater percentage of the workforce began earning degrees in pursuit of that dream, however, post-secondary education went from an exceptional qualification to a requirement for all but the lowest-paying entry-level positions. In the process, parents and students alike began to rate the importance of attaining a degree even higher and became even more willing to saddle themselves with punishing debt levels to obtain that degree. With the help of a student loan industry that has grown up to help furnish that debt as easily as possible, tuition has skyrocketed. The cost of a four year public college degree in America has grown 72% since 2000, according to a chart compiled by Citi. That's 5.6% per year, or almost double the official (fudged) CPI figure.
The greatest sign that the bubble will be popping sooner rather than later is that the writing is already on the wall that whatever return on investment students and their parents are expecting from these loans are not going to be realized. During the same period that tuition increased by 72%, earnings for college graduates decreased by 14.7%, or 1.6% per year. Simply put, students are spending much more (or, more accurately, borrowing much more) for the privilege of earning significantly less. Once this stark reality begins to sink in with students who suddenly find themselves slipping into bankruptcy or moving back in with Mom and Dad when they're unable to service their loans and still have enough to live on, the party will come to a crashing halt.
So how can the youth of today avoid this bubble? Well, the simplest way is not to enter it at all. There is simply no way to justify taking on as much as six figures of debt for a four-year liberal arts degree or other non-technical qualification in the current economy. Even those earning degrees that are still thought of as useful qualifications for technical positions, like engineering students, are seeing diminishing returns on their tuition investment and an increasingly unstable job market. In fact, even the Bureau of Labor Statistics says that 7 of the top 10 fastest growing jobs in the next decade are going to be positions where workers qualify through on-the-job training, not higher education.
Bubble #3: The Bond Bubble
You know it's bad when the Bank of England's 'director of financial stability' plainly states: “Let's be clear. We've intentionally blown the biggest government bond bubble in history.” It can't get any clearer than that. Government bonds are in a bubble that has been created not by the “irrational exuberance” of the markets but by the central banks themselves. And let's not forget that key adverb: deliberately.
Of course, anyone with eyes to see or ears to hear already knew this. This is precisely and admittedly what QE 1 and 2 and 3 and infinity were all about. This is what the Bank of England's current round of stimulus is about. It's what Japan has famously begun doing full-tilt with the advent of “Abenomics” and the changing of the guard at the BOJ. Central banks around the world are propping up bonds by buying them outright, in the Federal Reserve's case to the tune of $45 billion worth of long-term treasuries a month, or half a trillion dollars a year.
We know this is a bubble. We know, too, what it will look like when the bubble pops. We've seen what occurred last month when Chairman Ben gave even the slightest hint of a tapering in the bond-purchasing programs: equities tanked, the dollar strengthened, and yields spiked. This is exactly what we would expect from an asset that has been artificially inflated through government interference.
So how does one prepare for the popping of this bubble (or at least it's coordinated deflation) as the punch bowl of stimulus is removed from the party? Those that play the markets believe the key is to be as liquid as possible and prepared to move money into whatever asset class becomes cheap. Many investment advisors point to the 2008 junk bond market or the 2010 muni bond market as examples of buying opportunities where assets were dumped and traded significantly under value for a brief period. This, they argue, will be the best strategy in a post-QE environment. Others say to dump bonds before the bubble bursts and get into dividend-paying blue chip stocks, as the money that comes out of bonds is going to find its way into equities eventually, and the flight to safety effect will see the biggest and most stable returns coming from dividends.
Others see the popping of the bond bubble as the second act of the “greatest depression” that began in 2007. Just as the Great Depression saw multiple waves of banking failures and economic setbacks, so too has the initial panic of 2007-2008 been interrupted by years of quantitative easing. Once that is ended, according to this theory, we will be straight back into the depression. In this case, the rules for surviving economic collapse that we've discussed here before will apply. At the very least, those relying on bonds to fund their retirement (assuming that retirement is approaching and they are already committed to the strategy) should at least consider laddering their portfolio to maximize their opportunity to pull out or reinvest as needed.