Month: March 2021

Threat of rising inflation could burst any number of asset bubbles

Posted on by j.giglio

Identifying an asset bubble is not easy. They are only obvious after the bubble has burst – time alone gives definition. Americans may soon get another lesson in asset bubbles. The threat of rising inflation could burst any number of them.

One working definition of a bubble is when an asset’s market price far exceeds its fundamental value and is not justified by estimated price earnings. Artificially high asset valuations that are based on misconceptions that distort reality.

There is certainly disagreement about what is the correct measure of price earnings and one can only estimate fundamental value. Even if the diagnosis is correct, you don’t know when the bubble will burst.

Put simply, bubbles are booms that went bust, followed by a crash – a rapid decline in market prices. After all, that is what bubbles are supposed to do.

Bubbles make for interesting stories. Charles MacKay’s classic book, “Memoires of Extraordinary Popular Delusions and the Madness of Crowds,” was first published in 1852 and is still in print. Fabled asset bubbles are the Dutch tulip bubble of the 1630s, the South Sea and Mississippi bubbles of 1720, the run-up in American stock prices in the 1920s, the dot-com bubble of the late 1990s, and the housing bubble of the mid-2000s, when U.S. housing prices were 50 percent above their long-term trend.

Today there may be asset bubbles in specific markets, such as housing, cryptocurrencies, and stocks. U.S. housing prices rose more than 10 percent last year. The housing market is booming for one key reason: low interest rates. Prices for cryptocurrencies, an asset that doesn’t produce cash flows, rose more than 500 percent in the last year. This surge in the price of unregulated cryptocurrencies such as Bitcoin and Dogecoin has attracted the attention of many investors.

Then there is the incredible explosion in Special Purpose Acquisition Companies (SPACs). This is a company that is formed strictly to raise capital through an initial public offering for the purpose of acquiring an existing company. Also, known as “blank check companies,” SPACs have been around for decades. But new issuance of SPACs has skyrocketed over the past year. Over $75 billion was issued in 2020. Less than three months into this year, they have raised more than $78 billion.

The U.S. stock market ended 2020, another year that will live in infamy, at record highs. After bottoming out during the initial COVID-19 lockdown in March, the S&P 500 rose 68 percent in 2020, finishing the year up more than 16 percent, shattering all-time records along the way. The Dow Jones Industrial Average and the tech-heavy Nasdaq gained 7.25 percent and 43.6 percent respectively, despite the public health and economic crises.

One condition that typically accompanies asset bubbles is easy credit that turbocharges speculation and benefits borrowers.

Federal Reserve Chairman Jerome Powell is continuing the massive expansion of money and credit. Americans hope these policies don’t make a monkey out of Darwin.

Powell recently said the Fed won’t raise rates until they see a 3.5 percent unemployment rate and inflation averaging better than 2 percent. Inflation in not high on the Fed’s list of worries. Their top concern is mending the labor market. Both the Fed and the Biden administration are focused on getting the 10 million unemployed back on payrolls.

The bond market appears skeptical about letting inflation rise as 10-year bond rates are increasing – a signal from investors that they expect higher inflation. The bond market is apparently concerned that inflation would cut into buying power and force the Fed into rate hikes that could pop some of these asset bubbles that inflated thanks to rock-bottom interest rates, creating big risks to the economy.

To strike an optimistic note, if faintly, the accelerating rollout of COVID-19 vaccines has set the stage for rapid economic recovery in the second half of this year, hopefully with limited inflation. So, place you bets accordingly.

Demystifying the rule of law

Posted on by j.giglio

America’s constitutional order is under great stress and foundational principles such as free speech and the rule of law are under attack. The breakdown in respect for American institutions has helped instigate a season of violence and unrest.

The rule of law (ROL) is an expression most Americans are familiar with. It is a popular but vague term often used in political and economic contexts. Americans routinely hear politicians, judges, legislators and prosecutors mention the ROL right up there with freedom and democracy.

Few have paused to say what they actually mean by it. The concept is defined in many ways. For starters the ROL is an ideal, something to look at as a standard, a criterion. It is another way of saying that laws as written are applied equally to everyone. The ROL in its most basic form is captured in the popular quote “no one is above the law.”

It also means that laws should govern a nation and its citizens, as opposed to power resting with a few individuals. In theory, the law of the land is owned by all, made and enforced by representatives of the people.

The notion of the ROL comes with a host of concepts, like the law should be clear, known, and enforced; people are presumed innocent until proven otherwise; the police cannot arbitrarily arrest or detain people without good reason. Laws are interpreted by an independent judiciary which provides for the peaceful settlement of disputes.

The ROL requires that the law be enforced equally.  The most marginalized people in our society are entitled to be treated exactly the same way as anyone else.  It also requires that laws should not discriminate against people for no good reason, such as the color of their skin, their nationality or gender.

The concept of the ROL dates back thousands of years.  For example, the ancient Greeks started democratic law courts back in the 4th and 5th century BC with juries that had hundreds of members.  At Runnymede in 1215, English leaders signed the Magna Carta (Latin for Great Charter).

One might argue that the exalted Magna Carta was the beginning point of English-speaking peoples’ understanding of the ROL.  It was a document in which, for the first time, monarchs and government leaders agreed to subject themselves to the law, recognized that people were entitled to equality before the law and had a right to a jury trial.  The immediate practical consequence of Magna Carta was the establishment of an elected assembly to hold the monarchy to its side of the bargain.  These were momentous new concepts.

In the U.S., the most visible symbol of the ROL is the constitution, which was drafted by a special convention in Philadelphia in 1787.  It is the framework for effective and limited government and the supreme law of the land.  A congressman once delivered one of the truest statements of American political theory: “There is a straight road which runs from Runnymede to Philadelphia”.

The American effort to make good on the promise of the ROL has been difficult and sometimes bloody.  There is no getting around it – America has struggled to create a legal system that is fair to all its people.

The most glaring example is that the U.S. Constitution did not address the problem of slavery, despite the words in the Declaration of Independence that “all men are created equal”. This was the great flaw in American constitutional history.

America and other countries subscribing to the notion of the rule of law have considerable hard work to do to negotiate the distance between the ideal and the reality on the ground.