At the end of a spectacular 2014 for U.S. stock investors, I feel justified tooting my own horn. In the first quarter of 2013, when the Dow pushed past its 2007 record of 14,000 and skeptics were warning of a new bubble, I wrote in the April 2013* Researchthat the stock market advance had plenty of room to continue. That was countless daily record closings ago, which added up to a cumulative 25 percent gain for the Dow as of end-November.
Then, more than a year ago, I cautioned about a pattern that has emerged under two-term U.S. presidents: a liquidity-driven economic boom degenerating into a financial bubble and resulting in progressively more severe economic debacles. The first big bubble burst on Ronald Reagan’s watch in October 1987, the second implosion damaged the end of Bill Clinton’s presidency after March 2000 and the third sank the end of George W. Bush’s second term when Lehman Brothers went bust in September 2008.
In that November 2013 column, I wrote about a potential Obama bubble. And now not only is a stock market bubble upon us, but the entire worldwide asset bubble may be starting to deflate, albeit slightly ahead of schedule.
There has been a 2,000-point gain for the Dow since I wrote that piece, and a rise to 4,900 for the Nasdaq Composite. The tech index has come within 150 points of its March 2000 record, which was once thought to be unattainable, something like the 1989 record for the Nikkei 225 average in Tokyo when it touched 39,000. (The Nikkei, incidentally, is in a bubble of its own. After trading below 10,000 at the start of 2013, it has now shot up by 75 percent. However, it is still trading at less than one-half of its old record.)
For all the fantastic results in the U.S. and Japan, it was not a strong year for stocks elsewhere. Market indices in the eurozone, the U.K., Hong Kong and Brazil either scored mediocre gains or were flat. However, their underperformance — which reflected a slowing or stagnating global economy — actually benefited Wall Street, and not only because U.S. economic growth has been so strong.
To be sure, profits of U.S. companies, both blue chips and tech, continued to rise through the third quarter. March–September was the strongest six-month period for America’s GDP in a decade, and even taking into account a weather-related drop in economic activity in the first quarter, the U.S. economy is clearly humming. The labor market is improving, with the jobless rate falling to a six-year low. Consumer confidence is rising and household plans to buy durable goods are at a six-year high while plans to buy motor vehicles are at a nine-year peak.
The news on the economy would be positive under any circumstances, but in a normal cycle investors’ joy would have been tempered by fears of an imminent monetary policy tightening. As a former Federal Reserve governor once said, the central bank’s job is to take away the punch bowl just as the party gets going.
But not this time. That’s because the rest of the world has not only failed to keep pace with the U.S. economy but is slackening badly. Japan is in a recession and is suffering from deflationary pressures; in November, the Bank of Japan increased its already massive asset buying program further, from 60–70 billion yen a year to 80 billion yen. Bank of China, meanwhile, cut its interest rates for the first time since 2012, to their lowest level in four years. In Continental Europe, inflation nears zero, raising fears of deflation and prompting the European Central Bank to declare its readiness to buy sovereign bonds to combat another financial crisis.
This is not an environment that leaves room for the U.S. Fed to raise its rates. While the Fed stopped its own bond buying program and investors have started to discount its first tightening in a decade some time in 2015, it is now clear that the repo rate will remain on hold for a lot longer — in fact, until the global economic situation changes substantially. As it is, the dollar has been rising across the board, reflecting the inflow of liquidity into the only accelerating major economy, as well as into its booming stock market.
Black gold down
When oil prices dropped by some 30 percent in the second half of 2014, initially it was good news both for consumer confidence everywhere except in oil-exporting countries and for stock investors around the world. In the U.S., where lower crude prices quickly translated into cheaper gas at the pump, there was euphoria at the start of the holiday shopping season and a final confirmation that the Fed would not be tightening.
But uncorking champagne may have been premature. Falling oil prices may not augur the coming of some golden age for consumers and investors — and not only because the U.S. is now one of the world’s top producers of crude thanks to the shale oil boom. Rather, it is because the oil price drop represents the popping of a major financial bubble, which first started to inflate in the late 1990s, when oil fetched $10 per barrel, and reached its height in mid-2007, when the same barrel cost $147.
The oil bubble didn’t fully deflate after the 2008 financial crisis, primarily because the Fed and other major central banks revived the collapsing financial system with massive inflows of liquidity, but now the bubble may be finally popping.
Looking back over the past two decades, we see that the highly dynamic and flexible modern economy is also characterized by serial bubbles that tend to deflate sequentially, one after the other. In late 1996, then Fed Chairman Alan Greenspan warned of “irrational exuberance” on Wall Street. The following year the global bubble started to deflate in Asia, affecting the rapidly growing Pacific Rim Tigers with what came to be known as the Asian flu. In 1998, Russia defaulted and the U.S. came close to being sucked into the vortex with the failure of Long-Term Capital Management. But the hedge fund was bailed out and the U.S. crisis was postponed by some 18 months, when the dot-com bubble finally burst.
Fast forward to the 2008 debacle. It was foreshadowed by a peak of the Dow in October 2007, which was followed by an accelerating decline. Even as stock prices were slipping, the oil price bubble reached its highest point, topping $147 per barrel in July 2008. But by the time Lehman went belly-up in September, both markets were in a freefall.
Coping with deflation
We’re seeing an extraordinary situation: The U.S. economy is gaining steam but deflationary pressures are intensifying. Lower oil prices and a more expensive dollar are adding to the pre-existing trends pushing prices lower, such as global competition and advances in technology. Store sales were below expectations in the early days after Thanksgiving, which was another sign of deflation. Online sales are surging precisely because consumers are certain that they’re going to find a better deal by searching the Internet—and since they invariably do, consumer prices decline across the board.
Deflation presents a severe danger to the economy. Consumers delay purchases, leading to slower economic growth, corporate profits suffer, job creation and wage growth are undermined. Deflation is especially dangerous for inflated asset prices, including not just stocks but overheated real estate prices in popular world capitals such as London and New York.
However, while world central banks have been able to defeat inflation, their track record as far as deflation is concerned has not been proven. Interest rates can’t be lowered any more, and printing several trillion dollars in quantitative easing programs has been of questionable validity.
At the height of the Depression, the Fed admitted that it can’t do anything to counteract falling prices and contracting economic activity. John Maynard Keynes reportedly described this situation as “pushing on a string.” It has not been repeated since — because inflation has been the enemy for most of the post-World War II period. Now deflation is starting to take center stage.