Beware of Overpriced Assets

The delirious exuberance of stocks today is reminiscent of the stock market just before its earlier peaks in March and April 2000, and in the fall of 2007.  Prices move up in defiance of risks and uncertainties.  Stock indices set records every week.  Bulls overrun the markets.  Bears have become a seriously endangered species.

Even as financial messiahs proclaim a brave new market in spite of the stumbling economic recovery in America and recession in the rest of the industrialized world, let us recall the sources of the last two market busts:  highly overpriced assets.  In the late 1990s, the bubble was in tech stocks.  In 2007-08, housing and real estate mortgages were grossly overpriced.  In both instances, the sheer quantity of inflated assets ensured that when the markets turned, losses would be enormous.  Given the dazzling rise of stocks over the past few years, it behooves us to ask if there is a comparable risk today?

The answer would appear to be yes.  Investors have poured vast amounts of money into bonds of every stripe and variety.  Bond valuations, even of junk bonds, have reached highly optimistic levels.  Bonds are priced for perfection.  If any imperfection appears, losses--and a lot of them--will follow.

The most obvious risk to bondholders is that the Federal Reserve and other central banks will step back from the extremely accommodative policies they have instituted.  This will happen sooner or later, probably sooner in America and later in Europe and Japan.  When it does, bondholders will incur losses, and those losses will be big simply because of the huge amounts of money that have flowed into bonds. 

The Fed seems to think it can manage the process of shifting from quantitative easing to unwinding its $3 trillion plus balance sheet (i.e., quantitative tightening).  Perhaps it can do so without causing severe short-term turmoil in the markets.  But it can't circumvent a basic problem:  when interest rates rise and bond prices fall, a lot of losses will be incurred.  These losses must land somewhere.  They might be shifted from one investor to another by means of derivatives and other hedges.  But someone, ultimately, has to take the loss. 

The fact that losses in the financial markets have to land on someone somewhere wreaked havoc on the world's major economies following the real estate crash of 2007-08.  Investors around the globe who bought mortgage-backed securities, CDOs, CDOs squared, and other such financial alchemy paid the price for drinking too much of the Kool-Aid du jour.  We live with the resulting economic pain even to this day.

The bond markets are like a coiled spring that presents a similar problem. Extremely high prices have been paid for bonds, and bondholders face serious risk of losses when rates rise.  The sheer quantity of potential losses is the scary thing.  Those losses will have to land on someone, somewhere, and that will be painful.  The Fed's quantitative easing program has only exacerbated the risks, and the Fed's near term success in preventing depression has burnished its image of competence, which may have blinded bond investors to the dangers of the market downturn that must take place eventually.  As history repeatedly has demonstrated, the Fed is fallible and its fallibility is accompanied by serious consequences for the financial markets and the economy.

By promoting ultra low interest rates for five years, the Fed has allowed a massive build-up of investment in overpriced bonds.  While central bank intervention in a crisis is to be applauded, a years-long distortion of market forces will surely do bad things, and bad things have been done.  The only question now is when and how we will suffer the consequences.