Green Shoots or Smoking Weed?

Written by Niels Jensen

Saturday, 20 June 2009 17:12

Asset bubbles are strange animals. Ideally, you would like to punch the air out of them before they become a real danger, but it is not quite so simple in practice. Ben Bernanke and Alan Greenspan have actually both argued that asset bubbles cannot be detected and monetary policy should not in any way be used to offset suspected bubbles

I am not sure I agree with the two gentlemen, but that is less relevant for now. What is important to understand is what happens once the asset bubble bursts. In my experience, almost all post-bursting bubbles share two characteristics:

1) At the very least, asset prices revert to the mean, although many actually overshoot on the downside.

2) A long (and often painful) period ensues, where asset prices gradually claw back lost value. History suggests that this period is measured in years and sometimes in decades; asset prices have never recovered from a deflated bubble in just a matter of months.

At this point, the recent collapse of residential property prices is more advanced in the U.S. than in Europe and is a classic asset bubble that is now deflating. The reason I have decided to write about it this month is because the ‘green shoot’ campaigners are missing a hugely important point about the effect that falling U.S. property prices are going to have – not just on the United States but also on the global economy.

Make no mistake – I always expected and continue to expect an economic revival later this year, which unfortunately will prove temporary. There are many good reasons to expect such a short-term recovery, as I discussed in detail in the April issue. However, it is what happens afterwards that I worry about. The economic uplift is likely to last no more than one or two quarters after which we will have to face more gloom and doom.

There are at least two reasons property prices are so important to the overall economy. The first reason has to do with leverage. There has been a lot of talk about de-leveraging in recent months, and the consensus seems to be that most of it is now behind us. Perhaps, in the narrowest possible sense, that is correct. But leverage is not confined to hedge funds and banks. Many private households run heavily levered balance sheets as a result of their home ownership and it is this leverage that is rapidly growing at the moment. Why is that? Leverage is a function of both the numerator and the denominator and, as American homeowners are about to find out for the first time, falling property prices can have a devastating effect on your balance sheet.

This is an excerpt from June 2009 issue of Trader's Journal.