Are We in Another Bubble?

Nouriel Roubini, aka Dr. Doom, put himself back in the headlines last week by predicting the next great financial crisis. Roubini, as you know, became a household name for seeing just how severe the financial crisis would be, at a time when most economists were confident it would be confined to housing. While he believes we're finally pulling out of it, he says the next Big One will strike in six to 12 months.

What's worrying Roubini is an investment bet called the carry trade-made possible by the weak dollar and near zero interest rates in the U.S. In the carry trade, speculators borrow in the U.S. at ultra low rates and invest elsewhere-in emerging-market stocks and bonds, gold, oil, euros, whatever. As long as the dollar stays weak and U.S. rates low, it's a way of minting money, and every hedge fund and Wall Street trading desk in the world is doing it, according to Roubini.

The problem is, the dollar can't fall to zero. And U.S. rates won't stay low forever . When that trade reverses, panicky speculators trying to get out of the assets they bought with borrowed money will create what Roubini calls "the biggest co-ordinated asset bust ever."

Now, I actually don't want to get into whether Roubini is right. Felix Salmon, Reuters' economics uberblogger, believes him. David Rosenberg, the bearish economist at Canadian money manager Gluskin Sheff, has his own debt-driven doomsday scenario, which as of Monday now features a 13% unemployment rate in 2010. And after a 60% rally in the market over the past eight months, it's sensible to be worried that the markets have gotten ahead of the economy.

On the other hand, as Larry Swedroe points out in his CBS MoneyWatch.com blog, Warren Buffett just bought Burlington Northern railroad-not the action of a man worried that the carry trade is about to hogtie the economy. Do you want to bet against Buffett? And James Paulsen, the optimistic chief investment strategist of Wells Capital, thinks all this anxiety is typical at the start of a sustained bull market.

As often happens in a volatile market, then, you're now torn between two highly plausible, totally contradictory views of the future. The key question is, what should you do about it-or about any extreme market forecast. And I'd answer this way.

1. You have to remind yourself that the future is unknowable. Roubini is a smart guy, but he's also what decision experts are coming to call a "hedgehog," after Berkeley professor Philip Tetlock's great research on predictions, Expert Political Judgment. Hedgehogs are forecasters who tend to see the world through a single, unique lens (in Roubini's case, a persistently pessimistic one). When hedgehogs are right, they're spectacularly right. But they rarely foresee turning points.


2. Think about where you'd want your money if Roubini is right. In the unwinding of the massive dollar short sales, Treasuries and cash equivalent investments like bank accounts would be the only safe places.


3. Then, as you should do before you take anyone's investment advice, ask, "What if he's wrong?" In this case, if you put all your money into low yielding Treasuries and cash, you'd earn next to nothing in yield and you could miss an ongoing bull market in stocks. Bull markets don't come along all the time, and if you miss them, you miss the whole reason for owning stocks.

So, in the end, you have to hedge your bets. Keep enough money invested safely in money funds or the bank, along with a healthy dose of Treasuries: You want to make sure you can survive a Roubini-esque meltdown. If he really has you worried, put more into Treasuries and less into stocks than you ordinarily would.

Yes, we all wish we had listened to Roubini two years ago-just like we wish we had listened to Paulsen and Buffett in March. But you can't time the market, and you can't capture the profits of the past. Hedging your bets isn't the world's most exciting answer, but it's the only one that makes sense in an uncertain world.

Continue reading on CBS MoneyWatch.com:

Photo courtesy of Flickr user Esthr, C.C. 2.0

 

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Comments

[James Altucher - Huffpost Blogger]

Roubini is wrong. There is no carry trade. A carry trade occurs when someone borrows at low interest rates (like the US has) and lends out at high interest rates. No hedge fund is borrowing significant money and putting it blindly into US stocks. If they do that they usually hedge themselves (with merger arbitrage or convertible arbitrage or some other hedging strategy).

And, lets hypothetically say there is a carry trade. Thats the sort of trade that doesn't unwind overnight. The last equivalent era (2001-2007) lasted six years before it unwound and we are nowhere close to that type of bubble.

[joebaggadonuts]

Thanks for the analysis.

Point 1 is obvious to the sentient observer, but clearly bears repeating. Points 2 and 3 are also good to remember. The trick is to allocate between points 2 and 3 the best split of investment resources or to simply trade with the markets.

To say that you can't time the markets is an old rusty saw, and it needs sharpening. You can, short term, time markets if you follow the rules of preservation of capital laid out by the traders of old. But you have to continually pay attention, modify your strategy when it's wrong and take occasional hits because you will never always be right. Anyone with a full time high stress job doesn't have time to pay this kind of attention and will lose more than they win. Given the machines and people working full time against you in all probability you will not win most of the time even if you are paying attention, so those preservation of capital rules (never betting more than 1/20th of your wad on any trade, keeping losses low by taking them early, etc.) are essential but not enough to save you. Nevertheless it's the only way to make point 3 work. If you don't believe you can make point 3, putting money in the market work, then stick with point 2, or just go out and buy the fanciest house you can afford, or alternatively, a house and survival stuff off the grid.

[Rule Of Law]

Re: pending state budget problems--

The report by the Pew Center on the States found that Arizona, Florida, Illinois, Michigan, Nevada, New Jersey, Oregon, Rhode Island and Wisconsin are also at grave risk, although Wisconsin officials disputed the findings. Double-digit budget gaps, rising unemployment, high foreclosure rates and built-in budget constraints are the key reasons.

http://www.huffingtonpost.com/2009/11/11/10-states-face-looming-bu_n_354228.html

[Rule Of Law]

Given that none of the underlying systemic flaws on Wall Street have been dealt with we Will see another chapter in this unfolding Depression, just as Roubini prophesizes.

The carry trade is a huge market, but so is commercial real estate which has yet to see the same adjustment that housing has undergone. Also waiting in the wings is the altogether too likely crash of municipal bond markets across the nation as cities and states become unable to make good on their debts.

There is more, too much for this space, but bear in mind--without job creation, a real reindustrialization program that puts Americans back to work and rebuilds our infrastructure, there will be even less money going to DC in taxes to run the country as well as less going to the banks to continue the gambling. The future is not pretty. And hanging the term "hedgehog" on Roubini is an act of desperation.

[lightningbolt]

The entire reason for the bailout and lowering interest rates was to create another bubble to cover up the collapse of the previous one. This keeps happening over and over and over.

[azphoenixwolf]

Think about where you'd want your money if Roubini is right. In the unwinding of the massive dollar short sales, Treasuries and cash equivalent investments like bank accounts would be the only safe places.
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As unemployment is going up the commercial real estate bubble is getting ready to bust.
Tax receipts are down according to some by 30% and that will mean the coming loss of 900,000 state and local government jobs in the near future.
Thousands of media print jobs and snail mail jobs have been lost to the internet and are not coming back. USAToday circulation is down 17% and circulation in general by 10%. Those jobs are never coming back - add them to the outsourcing.
The FHA red ink is rising. Wait until the ARM mortgages reset and a tsunami of foreclosures will hit the market (a friend of mine's ARM reset $400/month higher and he had to short sell his underwater house.
The FDIC reserve has gone negative in the billions of dollars (they insure our "safe" bank accounts) due to rising bank failures.

[James Altucher - Huffpost Blogger]

Commercial real estate is a small percentage of residential real estate and CRE-linked bonds are already getting refinanced. This is not as big a worry as people think.

[berensma]

I think Warren Buffett's purchase of Great Northern RR is actually a long-term buy, with very little to do with current cycling (except a desired to avoid it). If anything, a conservative, long-term purchase such as this should make us *more* worried about shorter-term issues such as those raised by Roubini.

[James Altucher - Huffpost Blogger]

Lets not forget, Buffett also bet on Goldman at the bottom and won big on that. A conservative, long term purchase as Buffett's certainly does not make us more worried about the incorrect shorter-term issues raised by Roubini.

Buffett is betting on a retun of inventories (which were slashed to alltime lows in prep for the Depression that never came) and the shipping of those inventories, in the short-term, that will make the railroads thrive.

[artgurrl]

Nouriel Roubini is someone I would not bet against.

[James Altucher - Huffpost Blogger]

Maybe you should bet against him. His track record is horrible. Here it is:
http://bit.ly/3VcQey

Much better is to bet with John Paulson, who made billions betting against housing. What's his biggest investment right now? Citigroup. And then the hotel industry. He's betting on not just a return to normal but a boom in banking and commercial real estate.