How to Play ‘Spot the Stock Market Bubble’

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What’s cheaper than $85 billion of free money a month?

Talk of not printing $85 billion of free money a month.

The stock market didn’t like Bernanke’s suggestion that he might cut QE by 2014. Stock markets around the world were hammered and bonds sold off too.

The panic in financial markets was outdone by the panic in newsrooms to point out that the ‘tapering’ was conditional on the economy improving as forecast. (The Fed’s forecasts have consistently been overoptimistic since 2009.)

So are the central bankers in America really going to stop printing money? Probably not. Greg Canavan reckons it doesn’t matter anyway. A stock market bubble eventually pops, money printing or no. The question is, did the bubble just pop?

In another epic rant, CNBC’s Rick Santelli wanted to know what the Fed is so afraid of that QE is such a necessity in the first place. Hasn’t the economy been doing OK? Here’s the key part of his tirade:

‘So why can’t we take away the QE? I don’t get it! What are we afraid of? Do we have a Fed that operates like a day trader where every little gyration in the market every 10 minutes is all that matters? If you pull it away and the stock market goes down, where does it say in the constitution that some form of the government has to guarantee stocks go up, or guarantee that you have a house? They don’t! Where have we gone off the rails? Enough is enough.’

But what’s wrong with QE? Isn’t it making us all richer by pushing up stocks, which is keeping the economic recovery around the world going? That’s what the central bankers reckon, anyway.

The problem with the policy is inflation. ‘But we haven’t had any,’ I hear you say. True, inflation has been going steady near the targets set by central bankers. But we’ve still had a whole lot of inflation. It’s just hidden, as I’ll explain in a moment.

What’s more important to understand is that inflation doesn’t just cause problems by making your cost of living go up. It also causes distortions in the economy. Distortions which show up as bubbles that eventually pop, unleashing havoc on the economy. The tech bubble and global financial crisis showed this. A new bubble that has formed will show it again.

Remember, inflation didn’t run high in the 90s or 2000s. But bubbles still formed and then popped. So where is all the inflation? And how does it hide?

High Inflation at 2%

As the world gets more productive, prices should fall. People take that for granted in many things they buy. The iPhone 4 halved in price in 11 months from October 2011 to September 2012. That’s 50% deflation in the price of iPhones.

If that happened in the wider economy, there would be a financial crisis, according to economists. But iPhone maker Apple prospered. Hmm.

To avert a deflationary crisis, central banks maintain inflation around 2-3%. If they had decided to print enough money to keep iPhone 4 prices stable back in 2012, 52% inflation would’ve been necessary.

That’s because their inflation target is 2%, and so 2% more inflation than the 50% natural deflation is necessary. In that scenario, even though measured inflation was only 2%, the central bank engineered 52% inflation. And that’s how inflation is hidden in our economy today. Prices would be falling if it weren’t for central bank intervention.

The thing is, nobody could have known how much the price of iPhones would’ve fallen if the central bank prevented the fall in the first place. So you can’t actually know how much inflation the central bank is creating to make prices rise 2%.

And therein lies the crux of the world’s problems today. We never know how high inflation is really running, so we don’t know if there are distortions in the economy.

Even at the low rates of inflation we’ve seen the last few years, central banks may be engineering vast amounts of inflation to keep prices rising at 2%. They’re just offsetting deflation. But who knows how much by?

So, to understand what’s wrong with the economy and the stock market, you have to understand two things: 1, that measured inflation doesn’t measure inflation, and 2, inflation causes economic distortions like bubbles. But how does this theory stack up to history? Perfectly.

A History of Low Inflation Inflationary Bubbles

In the past, low interest rates were a hint that central banks were inflating bubbles. Even if prices were only rising 2%, the low interest rates were just offsetting a large amount of deflation. That caused distortions and bubbles to form.

George Selgin, one of the few economists who understands the difference between measured inflation and true inflation, pointed out in a speech to the Adam Smith Institute that this happened with the technology bubble of 2000. Economic statistics saw no inflation. No measured inflation in the CPI, that is. The price of things the government measures didn’t rise rapidly.

But that didn’t mean the central bank was doing nothing. What if inflation would’ve been -3% a year between 1990 and 2000? Then, creating say 2% inflation would mean a 5% intervention. 5% a year for 10 years gives you a 62% impact on prices. That’s a vast economic distortion. A distortion that can lead to something like the tech bubble.

When economists point out that the tech bubble couldn’t have been caused by the central bank and loose monetary policy, they are looking at measured inflation instead of measuring true inflation.

The same goes for the period between 2002 and 2007. Measured inflation was low. But how low was it really, if you measure it in terms of the deflation that was offset? It could’ve been even higher than 62%.

Most economists think bubbles caused by monetary policy must manifest themselves in inflation. They don’t realise how that inflation can be hidden. Or how hidden inflation can distort an economy. That’s why they keep missing the bubbles.

Let’s Play Spot the Market Bubble

The real worry is that economists are making that same mistake again today. And, if you’ll remember, it’s an expensive mistake for investors. The tech bubble and the 2008 crisis showed how expensive. So what signs should you look for that inflation is actually running amuck, even though measured inflation is low? How do you spot a bubble?

Well, it’s not difficult to do. That might sound rather pompous. But spotting bubbles really isn’t that difficult. Figuring out when they’ll pop is very difficult. That hasn’t stopped Greg Canavan from issuing an urgent warning to his subscribers.

Once you understand how bubbles form, hide and pop, you have a much better chance at success when it comes to investing. Here’s what I wrote to The Money for Life Letter subscribers on the 20th of May:

‘… I’d like to issue a warning about stock markets. I expect them to fall dramatically. Now I definitely don’t know that for sure. You can’t know that kind of thing for sure – especially the timing. And I don’t think it’s right to make dramatic changes to your investments and preparations for retirement based on a prediction like this. But I am suggesting you be prepared psychologically for a stock market crash.

‘I don’t know when, how far, how long or how quickly shares could tumble. The only question I can answer is the ‘why’. Shares around the world are benefitting from a flood of money and the expectation that the economy will improve.

‘But printed money creates an uneven and temporary flow of benefits. Printing money to improve the stock market and the economy is like changing the amount of millimetres in a centimetre to increase the size of your living room. It messes with measurements instead of reality.

‘Once you buy a bigger couch and it doesn’t fit, you’re left with a problem. The moment financial markets realise that same problem is baked into our economy, it will trigger a drop in stocks.’

In the following 23 days, the ASX200 index steadily fell almost 10%. The timing was a coincidence. But the reasoning and method used in the prediction is rock solid. So how can you spot bubbles for yourself?

Just look at what central banks are up to. To get a flavour of what you might want to look for, here is a chart from Societe Generale. It shows how Federal Reserve interest rates below GDP growth create bubbles. This worked for many of the bubbles of the past, as the chart points out.

The thing is, the divergence has never been bigger. So is the bubble bigger?

The answer is yes, but the chart is misleading. The bubble is far bigger than the chart suggests. Central banks have gone much further than manipulating interest rates this time.

They took interest rates to 0, and then kept right on by printing money. This chart show how the balance sheets of central banks around the world have expanded:

What’s really remarkable is that so much central bank intervention was needed to keep prices stable (rising at 2%). The amount of deflation they’re offsetting must be enormous. And therefore, the amount of distortion they’re causing must be gigantic. And therefore the size of the bubble must be humungous. And therefore the size of the crash will be …

Until next week,

Nickolai Hubble.
The Daily Reckoning Weekend Edition

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Nick Hubble
Nick Hubble is a feature editor of The Daily Reckoning and editor of The Money for Life Letter. Having gained degrees in Finance, Economics and Law from the prestigious Bond University, Nick completed an internship at probably the most famous investment bank in the world, where he discovered what the financial world was really like. He then brought his youthful enthusiasm and energy to Port Phillip Publishing, where, instead of telling everyone about The Daily Reckoning, he started writing for it. To follow Nick's financial world view more closely you can you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails.
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