 Executive Summary Do We Really Have a Bubble Economy and Why Should I Care? If the idea that a cluster of dangerous financial bubbles now threatens the United States and other world economies seems pretty outlandish to you, you are not alone. Conventional wisdom says the United States has and always will be the greatest economy the world has ever known, and there's no reason to believe the pessimistic naysayers and the perpetually paranoid chicken-littles who keep insisting the sky is falling. But what if there were a smarter, more realistic way to look at it? What if you didn't have to be blinded by wishful thinking nor consumed with fears of impending doom and gloom? What if you could see the factual evidence for yourself, come to your own reasonable conclusions, and prepare now to be among the wise few who will capitalize on what others initially miss? While most people will continue to ignore the warning signs until it's too late, smart, reasonable people can figure out how to survive and thrive under any conditions. The key is to face the facts early, use common sense, and act quickly and correctly. Facing Facts Let's begin with what most smart, reasonable people can agree on: Despite some recent gains, the current U.S. economy is sluggish and now faces some potentially significant destabilizing factors. For starters, we now have the biggest international trade deficit and domestic budget deficit in our nation's history. We also have record-breaking consumer debt, coupled with a near-zero savings rate. In many sectors, new jobs are not being created as fast as they used to be. Unemployment is creeping up in some regions, and many people who do have jobs haven't seen a decent raise in years. So, the first fact we face is that on every level of our economy-from overextended families to overextended businesses to overextended state and national governments-there is often more money going out than there is coming in. In and of itself, this doesn't necessarily mean we're in trouble. After all, a medical student might be in debt up to her eyeballs with no income to speak of and later go on to pay off all her loans and enjoy a very prosperous financial life. The same is true of national economies. Debt coupled with low income is not necessarily a bad thing. Like the medical student, governments can use debt as a tool to greatly increase prosperity down the road. It all depends on future potential. Which brings us to the next set of facts we face. What exactly is our economy's future potential based on what we know about present conditions? No one can say with certainty what tomorrow will bring, but reasonable people, given accurate information, can come to their own reasonable conclusions. Again, let's look at a few telling facts. We know we have a booming housing market that can't expand forever. We have a volatile stock market that climbs and falls as skittish investors dash in and out. We have a declining dollar that countries, such as China and Japan, may grow leery of buying in huge quantities. And even more pressing, we have a national economy that is heavily dependent on unprecedented low interest rates and low inflation rates that simply cannot last forever. Clearly, everything is not exactly coming up roses. But can we reasonably jump from these current realities to the conclusion that we have several linked bubbles that are about to simultaneously burst, sending a shockwave of troubles through the entire global economy? Most people would say no. But then, most people have never peeled back the skin of a bubble. Come inside and see for yourself ... What Is a Bubble? There is no formal definition within the field of economics that provides a precise way of identifying a bubble. For our purposes, we say a bubble exists whenever an asset's perceived or psychological value exceeds its real economic value. By economic value, we mean a value that is based on logical economic parameters, such as population growth, rising company earnings, increased personal income, or some other fundamental economic parameter that is directly tied to the asset's rise in value. On the other hand, if the asset begins to sell for a lot more than its economic value, and the price rises to two or more times the economic value, driven primarily by rising perceived or psychological value, then we say there is a bubble. It's important to understand that, in the early stages, every bubble goes up for very logical, economically sound reasons. For example, housing prices may increase because as population grows, more people want houses than there are houses available in a given area. Housing prices may also increase because as incomes rise, more people want to buy more expensive homes, which are in limited supply. In this case, the rising value of real estate is simply a matter of supply and demand. Limited supply and growing demand drive up prices. No matter how expensive homes become, as long as there are underlying economic reasons for the increase in price, there is no real estate bubble. But sometimes as prices rise for any asset, something else kicks in. Call it wishful thinking or just plain greed. People don't want to miss out on the benefits of owning something that is increasing in value, so more and more people want to buy. As demand goes up so does the price, but in this case, the underlying logical economic parameters are simply not there to support the price rise. After a while, the item in question may be selling for far above its logical economic price, based on logical economic parameters. Instead, the price rise becomes increasingly speculative and is based almost entirely on investment psychology. (For more information about what makes a bubble, please visit our web site at www.americasbubbleeconomy.com/bubbles.) While it's true that perceived value is the only value that matters when buying or selling in any marketplace, it is also true that, sooner or later, you cannot fool all of the people all of the time. Eventually, bubbles burst and perceived values fall to their true economic values. Real, rock-solid economic value rests firmly on real economic parameters, such as real profits, real productivity growth, real wage increases, and real assets gains. Pumped up, over-inflated bubbles do not. History is littered with countless examples of this, including the recent rise and fall of the Internet Bubble. Never mind that most Internet companies were operating in the red. Never mind that they often had little or no profits, and virtually no financial foundations from which to build. Never mind that any junior CPA fresh out of college could have easily figured out that the numbers just didn't add up. This was the mighty Internet! This was the new economic powerhouse that was going to drive us into the new millennium! The perceived value of high-tech stocks rose almost daily, despite the fact that with very few exceptions, most Internet companies had yet to make a dime, and more importantly, had very limited revenue potential. Then in March 2000, economic gravity kicked in and the value of Internet-related stocks crashed back down to earth. Billions and billions of investment dollars were lost. Many, many intelligent people were in shock for months, even years. In hindsight, of course, it all seems so obvious now. How could we have been so blind!? Why Are Bubbles So Hard to See? Bubbles are hard to see before they burst. Why? Because the short-term benefits of believing in them (namely, increasing asset values) are far more seductive than any vague ideas about some future, long-term downside. On the way up, bubbles are all gain and no downside, as long as you get out early enough. On the way up, the good times roll like there's no tomorrow. On the way up, we keep believing in the bubble because we want to believe, and most of the time that's all it takes to keep the bubble party going and growing-at least for a while. On the flipside, on the way down, previously invisible bubbles become instantly recognizable after they burst. Like waking up with a hangover you didn't anticipate the night before, a bursting bubble can be quite painful as assets that once seemed so solid and promising dissipate like fantasies in the cold light of day. The only way to enjoy the benefits of a bubble as it goes up, without experiencing pain as it goes down, is to get in early-and more importantly, get out early. We all know that when the price of anything is going up, those who buy first make the biggest profits. Conversely, when prices are going down, those who sell sooner rather than later, not only lose the least, they also can position themselves to make huge profits elsewhere. The trick, of course, is to see-and get out of-the bubble before it bursts. Can We See a Bubble Before It Bursts? There is no iron-clad, foolproof method for proving or disproving the existence and timing of a bubble. A lot has been written on the subject and we won't bore you with dozens of esoteric studies. When deciding if there is or is not a bubble, reasonable people needn't give themselves a degree in economics to be aware of these two key factors that make bubbles hard to see: 1) Esoteric economists are often too busy dissecting the trees to notice that the forest is on fire; and 2) Any analysis by the financial community, both public and private, rarely amounts to more than a sales pitch. People who have financial interests in making sure you continue to believe in the value of their assets, are often not the most reliable sources of accurate analysis. No used car salesman thinks the price of his vehicles are too high, and even if he did, he probably wouldn't tell you. Rather than trying to refute every esoteric economic argument or debate every financial cheerleader, we are going to simply lay out for you some very basic, very telling facts, and let reasonable people come to their own common sense conclusions about real or inflated values-one bubble at a time. If nothing else, the following bubble-by-bubble review should give you pause to reconsider some of the current conventional wisdom. As we've said, you needn't agree with all we say to position yourself now to take advantage of what many will miss. The vast majority of people refuse to see a bubble before it bursts-and herein lies a bonanza of opportunities for the lucky few who do. Our Asset Bubbles Will Fall in Two Stages: First Stage Due to Bubbles Bursting, Second Stage Due to Bad Economy It is important to point out that all asset bubbles (such as the Stock Market Bubble and the Dollar Bubble) will burst in two stages. The first stage will be the bursting of the recent over-valued price bubble. The second stage will be the additional fall in value due to the significant coming downturn in the economy. For example, if the value of a house has risen from $200,000 to $300,000 in the last 5 years, the first stage of the bubble fall may be a decline of the recent bubble price back to $200,000. Unfortunately, it doesn't end there. The second stage of the fall will involve a further value decline, below $200,000 (when adjusted for inflation), due to very high interest rates and a very slow economy. With many U.S. assets and asset bubbles, that second stage decline could be quite significant as well. Do We Have a Bubble in the Stock Market? There may be as many ways to analyze today's stock market as there are Blackberries on Wall Street. You can spend days studying the charts and numbers up one side and down the other, but all you really need to know is this: The value of U.S. stocks (blue chip stocks, not hyped high-tech) grew nearly 10 fold in the two decades from 1982 to 2000, while real earnings (adjusted for inflation) increased only three fold over this same time period. By contrast, in the previous 54 years from 1928 to 1982, the stock market, as measured by the Dow Jones Industrial Average, grew a much more reasonable three fold during a time of huge economic growth. If the real, underlying economic value of stocks had actually increased 10 fold in 20 years, we would also have seen a similar rise in real earnings and to some extent, gross domestic product (GDP). That didn't happen. Instead, investors have spent two decades making stock values defy gravity in a flurry of excitement that bestselling author Robert Shiller beautifully described in his book Irrational Exuberance. As we said before, perceived value is all it takes to set the price in any marketplace. But not forever. At some point, economic gravity kicks in, investors pull out, and the bubble pops. If a 10-fold increase in 20 years is not enough evidence for you, another way to decide for yourself if there is or is not a bubble in the stock market is to look at an old standby for assessing stock value-the price-to-earnings (PE) ratio. Under normal conditions, the value of a company's stock is directly related to that company's profits or earnings. When earnings go up, stock values go up. When earnings go down, stock values go down. But what if stock prices (adjusted for inflation) start going up faster than earnings? What if stocks keep on going up and up, no matter what the company's profits? Wouldn't that, by definition, be a bubble? As of mid 2006, PE Ratios are at about 25, rather than the average of 14-15, clearly indicating that most stocks are currently overvalued. High PE Ratios are fine, as long as everyone keeps playing the game and keeps on buying overvalued stocks. But if anything should happen to spook skittish investors into dumping their overpriced stocks, economic gravity will kick in, a sell-off will ensue, and stock values will drop. What could possibly spook investors? To answer that we need to see if there are any other bubbles floating around in today's economy. Do We Have a Bubble in the Value of the Dollar? As with assessing the stock market, there are dozens of ways to measure the merit of the dollar. Is it overvalued, undervalued, or right where it should be, based on real, underlying economic strength? Rather than give yourself a headache trying to analyze the many different views on this complex subject, here's all you really need to know: In the last couple of years, the Japanese Central Bank has bought almost a trillion dollars of U.S. currency. The Chinese Central Bank is not far behind, buying a whopping $800 billion of our cash. Why would a foreign government buy so much of our money? Good question. They do it for one simple reason: to keep the value of our dollar high so we can continue buying lots of their exports. Here's an even better question: Where would we be right now if China and Japan had not bought up almost $2 trillion of our cash? What would the dollar's value be if they hadn't stepped in and propped it up? And more importantly, what will happen to our dollar when they stop propping it up? Exactly when China and Japan will quit buying massive amounts of our dollars is hard to say (as of this writing, Japan has stopped at least temporarily, and is letting China pick up the entire burden), but this much you can count on: Anytime a nation's currency (or any asset, for that matter) has to be bought up in huge numbers in order to maintain its value, that is prima facie evidence of a bubble. Don't be snowed by complicated arguments. You can hold your own in any debate about the true value of any asset simply armed with this one deadly fact: If you have to manipulate it to keep it afloat, it's a bubble. It's that simple. The more complex question is when will this manipulation stop and the bubble burst-a question we take a stab at answering in Chapter 3. For now, all you need to know is that a solid, economically grounded dollar does not need foreign governments to buy massive amounts of it in order to prop up its value. If it's manipulated, if it's made to levitate despite economic gravity, if it floats like a bubble and it looks like a bubble ... it's a bubble. (Continues...) | 
The Daily Reckoning U.S. Edition
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