Traders are borrowing heavily... and that could spell trouble.
Nouriel Roubini, a leading economist and Professor at the Stern School of Business at New York University, recently questioned the sustainability of the recent stock market recovery, saying "Markets have gone up too much, too soon, too fast."
"So what?" I can hear you say. What use were most economists' predictions in the past couple of years.
Well, Roubini is no ordinary economist, as he was one of the very few people who actually predicted the coming financial crisis back in 2006, which is how he came by his "Dr Doom" nickname. I know a lot of people now lay claim to having predicted the financial crisis, but he is one of the few who can genuinely be given credit for laying his reputation on the line to do so.
There are two problems that he has identified:
The 'carry trade' in US dollars
Cheap US dollars are being used to make speculative purchases of risky assets creating in affect an asset bubble in commodities and global equities that could implode when the dollar appreciates and all the speculators rush for the exit at the same time.
He outlined this view in a recent article in the Financial Times:
"Let us sum up: traders are borrowing at negative 20 per cent rates [as the fall in the US dollar leads to massive capital gains on short dollar positions] to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius -- even if they are just riding a huge bubble financed by a large negative cost of borrowing -- as the total returns have been in the 50-70 per cent range since March."
As long as the US Federal reserve keeps interest rates low, this trade is going to continue growing, and the eventual pop could be rather nasty.
An unrealistic view on recovery
He reckons markets have priced in a 'V'-shaped recovery, essentially a rapid return to business as usual. However, any economic recovery could be far slower as unemployment is set to continue to rise at least until the end of 2010. He thinks the recovery is going to be more like a 'U'-shaped recovery at best.
In my view, this is a more realistic assessment of how things are going to be going forward. Indeed, there are even risks that it could develop into a 'double dip' recession. Therefore, I reckon there is a significant danger that there will be a market correction when US rates begin to climb back upwards.
What should you do?
Nouriel Roubini has acknowledged that part of the recovery since March has been based on economic fundamentals. However, it is only a part. So it's important not to buy overpriced assets, purely in the hope of making a profit from a rising market.
Warren Buffett's old adage, "Price is what you pay. Value is what you get", stressing the difference between price and value needs to be remembered at all times in order to avoid paying over the odds.
I'm trying to build in a 'margin of safety' when purchasing, just in case Nouriel Roubini is correct (again). Of course he is no prophet, but he has got some big calls right and I find it difficult to fault his logic on this rally getting way ahead of itself.
Incidentally, it has been reported that he believes buying and selling individual stocks to be a waste of time, preferring to track individual indexes. Now I'd say that view certainly isn't correct all the time, but probably is right most of the time. A bit like Nouriel himself.
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