Making sense of bubble talk: The bull vs bear case

Nazim Khanmoneycontrol.comCarl Icahn, Jeremy Grantham, John Hussman. This is not a list of one of the top money managers of the world. These are investors who have recently warned of an impending stock collapse, predicated upon their expectations of a major economic downturn.Add to that Nobel Prize-winning economist Robert Shiller and our very own Raghuram Rajan who have both said that the risks to the global economy suffering a similar collapse like the one we suffered in 2008 are high, and you can’t ignore the warnings.The common thread running through the arguments of each of the above-mentioned gentlemen is largely this: post the 2008 crisis, the US Federal Reserve’s response in embarking on a money-printing spree in its bid to kickstart the spending cycle will produce an unintended side effect. That instead of going into the real economy, much of the easy credit will go into speculation-prone asset classes such as stocks, bonds or real estate.Most of the world’s major stock markets have more than doubled since bottoming out in 2008/09.The bond market has not been left behind either: yields on government securities have touched historic lows in the years since in both the US and other developed markets.But is the dual rally in line with the economic recovery that has been witnessed since? Or have asset classes such as stocks and bonds run ahead of their fundamentals?Here are three arguments each put forth for each case.Valuations:Point: Leading the bubble talk is the discussion on valuations and whether they have run ahead of fundamentals.Shiller spoke to CNBC about the CAPE (cyclically-adjusted price-earnings), a measure he developed years ago and which has been shown to be useful in the past at predicting stock collapses.The CAPE, which uses an inflation-adjusted PE ratio of the past 10 years, stands at 25 – the last time these levels were seen were in 1929 (before the onset of the Great Depression), 1999 (before the dotcom collapse) and 2007.  Counterpoint: But as Shiller himself would admit, predicting a bubble and predicting a collapse are two different things. That is, an overvalued market can continue to get even more overvalued before correcting. A lot more. (For instance, Shiller himself predicted the US housing bubble in 2005 but it took two years for his prediction to come true.)That point was made by Jack Boroudjian, chief investment officer at Index Financial Partners, who called the current global stock rally as the “most disrespected” of his lifetime.“We have huge community of unbelievers,” he told CNBC recently. “We have had so many people in the last five years looking at the 10-year yield and saying this is a warning signal. Well, guess what? That has kept people on the sidelines and it's a shame because they've missed out in the greatest rally of our lifetime.” Sentiment:Point: “The primary driver of the market here is not valuation, or even fundamentals, but perception. The perception is that somehow the Federal Reserve has the power to keep the stock market in suspended and even diagonally advancing animation, and that zero interest rates offer “no choice” but to hold equities,” wrote John Hussman, manager of the Hussman series of mutual funds.“Be careful here…Given the current perceptions of investors, the Federal Reserve can certainly postpone the collapse of this bubble, but only by making the eventual outcome that much worse.”Counterpoint: According to money manager Richard Bernstein, stocks are currently “fairly valued” and in the middle stages of an elongated bull market.“The signs of exuberance and overvaluation that usually mark the end stage of a bull run have yet to emerge,” he said.He told MarketWatch that he had been inundated with headlines, notes and queries centered on fears that investors have grown complacent, setting up stocks for an inevitable fall.“The only rub is that if everybody is worried about complacency, it tells us investors aren’t complacent.”Policy risks:Point: The final argument is on the macro-economic side. That the US Fed’s zero interest rate policy may, in the absence of structural reforms to the economy, do little to boost economic growth and may instead become the cause of another full-fledged crisis down the road. “Extreme monetary easing, in my view, is more cause than medicine,” RBI governor Raghuram Rajan, who foresaw the US subprime bubble back in 2005 when he was an IMF economist, said at a recent speech. “The sooner we recognize that, the more sustainable world growth we will have.”Counterpoint: The counterpoint to that view comes from none other than Warren Buffett, who has consistently maintained that the world was better off with the Fed’s grand monetary experiments, despite their risks, rather than without them.“You can look back and say you could have done this a little differently or that a little differently, but at the time I called it an economic Pearl Harbor, and in the end we got through Pearl Harbor. And it could have turned out a lot differently,” he told the New York Times in the aftermath of the crisis.