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 MARKET REPORTS |
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Analysis
The biggest speculative bubble in world history has some unwinding to go
April 17, 2008
Steve Keen, Associate Professor, University of Western Sydney
Now that the bull run has given way to a confirmed bear market, and the US housing market is in free fall, the question on everyone's lips is "how low can it go?"
It's possible, using standard measures such as Price to Earnings or Debt to Equity Ratios, to argue that shares have already fallen sufficiently, and a recovery is in sight. But another, longer term perspective suggests caution--extreme caution.
This perspective, developed empirically by Robert Shiller of "Irrational Exuberance" fame, and theoretically by Hyman Minsky of the "Financial Instability Hypothesis", gauges the value of assets by comparing asset prices to the CPI. From this point of view, the unwinding of asset prices has a lot further to run.
Shiller argues that, over the very long term, there is no trend to the ratio of share (and house) prices to the CPI. It rises in a bubble, and falls in a slump, but generally returns to the same general range.
Minsky argues more prosaically that there are two price levels in a market economy--one for ordinary commodities and based largely on the cost of production, and another for assets that reflects people's expectations of the future. Expenditure on the former comes overwhelmingly from income, while asset purchases are overwhelmingly financed by debt.
Leveraged speculation can drive asset prices well out of alignment with commodity prices, but ultimately, they have to fall back in line with them. This is because, while individuals can do very well out of debt-financed speculation, at the macro level, debt must be financed out of income--and the ultimate source of income is the sale of commodities. So the ratio of asset prices to the CPI matters, because it tells us how hard (or how easy) it is to sustain asset prices at current levels.
From this analysis, we have been in the biggest speculative bubble in world economic history--bigger than the 1920s and far bigger than 1987--and the unwinding still has a lot further to go.
Historically, the speculative casino of choice for Americans has been the stockmarket. There have been obvious bubbles in shares before - of course in 1929, but also remarkably on this measure, in 1966 (the 1966 bubble had an even higher level of overvaluation than in 1929). The real stock price index took 30 years to get back to the same level after both bubbles.
Today's bubble makes those two previous peaks look like pimples on a mountain. The real Dow Jones index in 2000 was three times as high as its peak in 1929. Even to return to that level implies a further 60 percent fall in the index--and a fall of up to 75 percent to return to the long term average before this bubble began. 
The US housing bubble that commenced in 1997 as unprecedented: the CPI-deflated price of American housing had averaged 103 from 1890 till 1995, yet in the ten years from 1996 it more than doubled to a peak of 228. It has since fallen to 190, but still has another 45 percent to go before it returns to the long run average. 
Predictably, Australia's housing bubble is bigger than America's. Our data doesn't go as far back as the USA's, but for house prices to return to the level that applied in 1987 would require a 56 percent fall from current levels--and 1987 was itself a boom year. 
The Australian stock market data is also shorter than for America, but again the current bubble reached a peak of more than twice the average value between 1985 and today. Prices would need to fall a further 35 percent to return to the long term average. 
Of course, this could all be just Cassandra talk, and the asset road to riches could commence once again after today's temporary setbacks are behind us. But the debt levels we've accumulated, and the economic history after previous peaks in debt, imply that maybe this time we should listen to Cassandra. As the final chart shows, private debt today (relative to GDP) dwarfs the levels that ushered in the Great Depression--which was notably not a good time to be in shares, or property. 
Steve Keen publishes a monthly report called Debtwatch, maintains a blog on debt at www.debtdeflation.com/blogs, and has a website on economics in general at http://www.debunkingeconomics.com/.
More articles from this edition of CompareShares:
Superannuation: Keeping super and pension balances safe during market turmoil
Stocks: Big cap stock that defies market sell-off
Commodities: USD gold bull
Fundamentals: It pays to avoid dud stocks
Analysis: The biggest speculative bubble in world history has some unwinding to go
Resident trader: Trading for that big catch
Investing: Have we witnessed the market bottom?
Investing: Confounding connections – Aussie market following the US like a dog on a leash
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions.
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