Another Bubble Sooner Than You Think?


Not only is the next bubble unavoidable, according to few experts, the next asset bubble can come sooner than you think:

A year after the collapse of home values triggered the financial crisis and Great Recession, another rapid and irrational rise in the price of assets — whether stocks, home values, oil or something else — would seem unlikely. After all, major bubbles through history have been spaced decades, if not centuries, apart.

Today, though, amid the wreckage of the last bubble, the ingredients for the next are still with us. The price of gold spiking to its highest level ever — $1,060 an ounce on Thursday — is one warning sign, as is the 67 percent surge since March in the Nasdaq Stock Market index.

One reason is that there's a sharp rise in the amount of capital sloshing around the world in search of the best returns. Investors are still fixated on short-term gains over long-term performance. And information now travels instantly, fueling a herd mentality and feeding the optimism wired into our brains.

Bubbles feel good when they're inflating, but even that upside isn't a replacement for slow-and-steady growth — the type of economy the U.S. mostly had for decades. The problem comes when the music stops and the wreckage spreads far beyond the assets that were inflated.

After the housing bubble popped, we're lucky to still have a functioning financial system. And because millions of working Americans now depend on 401(k) plans instead of pensions for their retirement savings, they're more vulnerable when the stock market plunges as it did last fall.

"It's not a matter of could it happen again; it's a matter of when," says Kenneth Rogoff, an economics professor at Harvard University and co-author of a new book on bubbles called "This Time Is Different: Eight Centuries of Financial Folly."

Reckless day traders and unqualified home buyers got blamed for the Internet stock bubble at the beginning of this decade and the still-deflating housing bubble. But they're just bit players in the story. The surge of global capital seeking the quickest and most profitable investments played a larger role.

Over the last 30 years, the value of financial assets — such as stocks, bonds and bank deposits — grew to be four times larger than annual global gross domestic product. Key factors: personal savings rates rose in Asian economies, companies piled up profits year after year and Middle Eastern oil-exporting countries grew wealthier.

Mckinsey Global Institute estimates this measure of wealth peaked at $194 trillion in 2007. And while it fell back to $178 trillion at the end of last year, it is still dramatically larger than the $43 trillion in 1990 or the $94 trillion in 2000.

That money helped fuel the Internet boom. Billions of dollars in seed money enabled Silicon Valley startups to go public with only vague business plans — and attract more investors.

After tech lost its luster in 2000, capital stampeded into another promising asset: the U.S. residential housing market.

That money made it easy for millions of Americans — even those without good credit or money for a down payment — to get mortgage loans because global institutional investors were eager to buy the high-yielding securities the mortgages were packaged into.

Before last year's financial crisis, China had amassed $376 billion in long-term U.S. agency debt, mostly in assets issued or backed by mortgage-finance giants Freddie Mac and Fannie Mae.

Today, record-low rates for short-term loans in the U.S. — tied to the Federal Reserve cutting its target rate for overnight bank loans close to zero — are also now playing a role. And there's more incentive for money managers around the globe to use dollar-denominated short-term loans to buy stocks, commodities and other investments that typically deliver higher returns. That's contributing to the dollar's 6.5 percent decline in value this year against a basket of six major currencies.

As the dollar has fallen, gold, copper and other commodities priced in dollars have become cheaper for overseas buyers. Gold, for example, has risen 21.7 percent in the last six months in dollar terms. But measured in terms of the euro, the currency used by Germany, France and 14 other European nations, gold is up only 7 percent over that period.

While buying gold is viewed as a way for investors to protect themselves against inflation, it can be a way for money managers to profit off other investors' inflation fears. This is called momentum trading.

And as money managers shift funds around the globe in search of the highest returns, they often end up piling into the same asset classes so they can show clients they're wise to the next hot investment. This is the kind of herd mentality that leads to asset prices inflating beyond their fundamental value.

Harvard professor Rogoff and others say that's why tougher rules on risk-taking, Wall Street compensation and borrowing are needed. "Good policy changes could put off the next (bubble) by 50 to 75 years, instead of five or 10," he says.

Asset bubbles date to the 1600s.

During Holland's "Tulip Mania" in the 17th century, the slender flower became a status symbol and sparked a brief but ruinous bubble that saw tulip bulbs sell for as much as the price of a house before the market crashed. In the late 1800s, shares of U.S. railroads soared and crumbled. And just a few decades later, after the birth of the U.S. auto industry helped pump up the economy — and home prices — the stock market made its historic ascent and 1929 crash, triggering the Great Depression.

From World War II up until the 1980s, large-scale asset bubbles in the U.S. were rare.

World economies were tightly regulated and the flow of international capital was restricted, making it much harder for bubbles to form, says Carmen Reinhart, an economics professor at the University of Maryland.

It's a vastly different picture today. International financial markets have become deeply enmeshed, and the cross-border flow of money has ballooned, making the U.S. economy "much more crisis prone," Reinhart says.

It's true that credit is harder to come by today and that could temper the threat. But until lending standards are further tightened, a "misalignment" between the risks and rewards of investing with borrowed money will persist, says Mark T. Williams, professor of finance and economics at Boston University.

The Obama administration is calling for tougher measures against subprime lending to ensure only qualified borrowers get loans. It also has proposed limiting executive pay to discourage excessive risk-taking and making banks keep more capital on their books to safeguard against risky borrowing, or leverage.

Harrison Hong, an economist at Princeton University who researches bubbles, says the same short-term mindset that prods investors to pile into the next boom also allows them to forget the previous bust.

After the bursting of the tech bubble in 2000, it only took a few years before the same investors who lost money on Internet stocks turned their attention to real estate as home prices rose rapidly. "Memories are fairly short," Hong says. "My sense is that we're going to be in for a repeat of this stuff somewhere down the line."

Memories are very short. People who got burned in 2008 will want to make that money up in a hurry. Greed and fear are the only emotions that govern markets.

But knowing another bubble is heading our way doesn't help much unless you figure out where it's going to be. NPR reports Where's the next boom? Maybe in `cleantech':

Our economy sure could use the Next Big Thing. Something on the scale of railroads, automobiles or the Internet — the kind of breakthrough that emerges every so often and builds industries, generates jobs and mints fortunes.

Silicon Valley investors are pointing to something called cleantech — alternative energy, more efficient power distribution and new ways to store electricity, all with minimal impact to the environment — as a candidate for the next boom.

And while no two booms are exactly alike, some hallmarks are already showing up.

Despite last fall's financial meltdown, public and private investments are pouring in, fueling startups and reinvigorating established companies. The political and social climates are favorable. If it takes off, cleantech could seep into every part of the economy and our lives.

Some of the biggest booms first blossomed during recessions. The telephone and phonograph were developed during the depression of the 1870s. The integrated circuit, a milestone in electronics, was invented in the recessionary year of 1958. Personal computers went mainstream, spawning a huge industry, in the slumping early 1980s.

A year into the Great Recession, innovation isn't slowing. This time, it's better batteries, more efficient solar cells, smarter appliances and electric cars, not to mention all the infrastructure needed to support the new ways energy will be generated and the new ways we'll be using it.

Yet for all the benefits that might be spawned by cleantech breakthroughs, no one knows how many jobs might be created — or how many old jobs might be cannibalized. It also remains to be seen whether Americans will clamor for any of its products.

Still, big bets are being placed. The Obama administration is pledging to invest $150 billion over the next decade on energy technology and says that could create 5 million jobs. This recession has wiped out 7.2 million.

And cleantech is on track to be the dominant force in venture capital investments over the next few years, supplanting biotechnology and software. Venture capitalists have poured $8.7 billion into energy-related startups in the U.S. since 2006.

That pales in comparison with the dot-com boom, when venture cash sometimes topped $10 billion in a single quarter. But the momentum surrounding clean energy is reminiscent of the Internet's early days. Among the similarities: Although big projects are still dominated by large companies, the scale of the challenges requires innovation by smaller firms that hope to be tomorrow's giants.

"Ultimately IBM and AT&T didn't build the Internet. It was built by Silicon Valley startups," says Bob Metcalfe, an Internet pioneer who now invests in energy projects with Polaris Venture Partners. "And energy is going to be solved by entrepreneurial activity."

The action is happening at companies like GreatPoint Energy in Cambridge, Mass., which has developed a technique for turning coal into natural gas more cheaply and efficiently than previous methods.

GreatPoint plans to break ground next year on a power plant in Houston that will cost $800 million and create thousands of construction jobs, says its CEO, Andrew Perlman. Dow Chemical Co. and energy giants AES Corp., Suncor Energy Inc. and Peabody Energy are all GreatPoint investors.

"The opportunities," Perlman says, "are staggering."

A123 Systems, a Watertown, Mass., maker of lithium-ion batteries for electric cars, had one of the most lucrative public stock offerings this year, raising $437.5 million. Its stock price jumped more than 50 percent on the first day of trading in September, with investors willing to overlook that the company has yet to make money.

The Obama administration's promises about cleantech funding have galvanized the industry, reassuring entrepreneurs that they will have paying customers. The administration has said it will focus on putting more hybrid cars on the road, boosting the amount of electricity from renewable sources and investing in ways to cut pollution from coal.

One target is "smart grids." As utilities install digital meters in homes and Americans buy appliances that can communicate with the electric system, individual power consumption can be monitored more closely. People could be cued to dial down appliances such as refrigerators and air conditioners when electricity is in highest demand. Such fine-tuning in millions of homes can reduce the need for new power plants.

At Tendril Networks Inc. of Boulder, Colo., which makes software that links utilities to smart-grid devices in homes, the staff has tripled over the past five months to 90. CEO Adrian Tuck says Tendril could grow even more if some of the $4.5 billion earmarked for smart grids in this year's federal stimulus goes to Tendril's clients.

"What we're about to see is every bit as big as the telecom revolution that gave birth to the Internet and cell phones," Tuck says. "It's going to create as many jobs and as much wealth for this country, if they get it right. Big, Google-sized companies are going to be born in this era, and we hope to be one of them."

The government's push for these developments parallels the expansion of railroads in the 19th century, when the government granted blocks of land to companies laying track, says Jack Brown, an associate professor in the University of Virginia's Department of Science, Technology and Society.

One difference, Brown points out, is that clean energy is such a vast field that government could make the wrong choice in backing one type of technology over another.

It's not just startups getting in the game. General Electric Co. plans to string transmission lines to deliver solar or wind power. Hewlett-Packard Co. is adapting techniques for printer cartridge chips so digital sensors can send data to smart grids.

But how much of an economic boost does all this add up to? It's hard to tell — at least at this stage, without products people actually want to buy.

The laser, for instance, was a big innovation, but it wasn't clear at first what it could be used for. That's why there wasn't an economic boom in the 1960s from the advent of lasers, even though they ended up driving everything from medical devices to CD players for four decades.

Sung Won Sohn, an economics professor at California State University, Channel Islands, believes upgrading electric grids and finding new sources of power will provide steady job growth — but won't be an economic powder keg.

Clean energy projects could simply replace old jobs and functions, like meter-readers. And there's no guarantee new jobs won't shift to countries with cheaper labor.

Some innovations take longer to reveal their economic effects. There are big booms based on specific innovations — along the lines of railroads, automobiles and the Internet — and then there are technologies that grow slowly, spawning offshoot industries for entrepreneurs to exploit over decades.

For example, the emergence of the integrated circuit led to the development of computer microprocessors, which enabled the PC revolution and in turn the Internet age. There's every reason to believe energy technology will fall into the same category, Brown says, but he adds: "It depends on how the bets actually play out."

Will the next asset bubble come sooner than we think? Will it be in cleantech? Biotech? Nanotech? Infrastructure? Oil? Gold? Bonds? BRIC economies? Or will the next bubble be Canada? Yes, Canada! Nobody really knows, but big bets are being placed by some very big funds. The only thing I know is the world is awash with liquidity, a bubble is forming and we won't know about it until it's too late.

***UPDATE: Soros to invest $1 billion in clean energy***

Bloomberg reports that Soros to invest $1 billion in clean energy. He's not the only hedge fund manager making big bets in this sector.

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