Dr. Doom Sees Impending Market Crash

With stocks on a hot streak, the temperature of the equities market is rising. While your investment doctor tells you all is well and you have nothing to fear, you decide to get a second opinion.

Imagine getting that second opinion from a “Doctor Doom”. Now that would be a consultation you won’t soon forget.

This Dr. Doom is Nouriel Roubini, an economics professor at the Stern School of Business, New York University, with a doctorate in international economics from Harvard University. He is also the chairman of his own consultancy firm, Roubini Global Economics.

Credited with correctly predicting the collapse of the United States housing market and the global recession of 2008-09, Roubini has earned his nicknames “Doctor Doom” and “perma-bear” for his decidedly bearish points of view on the futures of national and global economies.

Consistent with his bearish stance, Dr. Roubini has a rather bleak outlook on the U.S. and global economies. And it is all due to the activities of the markets’ chief benefactors: central banks.

Two Opposing Forces

Believe it or not, Roubini actually believes stock markets will continue to rise – for a time – riding ever higher on this latest wave of positive investor sentiment. When asked at the SALT Conference in Las Vagas yesterday how much longer he thinks the equities bull run can last, Roubini acknowledged, “It could go on for another year or two,” as cited by Business Insider.

He then described the dynamics of two opposing forces pushing against each other, with the “gravitational forces of [a] slow economy” competing against the “levitational forces of QEs, zero policy rates, [and] more money coming in the market not just from the U.S. but [also] from other economies.”

The force gaining the upper-hand at the moment is the levitational force applied by central bank stimulus programs, which is clearly driving some economic growth. “For the next year or so,” he suspects, “as long as the economy grows 1.5-2%, and you have easy money, this market can go higher.”

But eventually the tide will turn, he predicts. “Growth is slow. Earnings growth is also slowing down. Top line and bottom line are not as good as they used to be, but margins are high. They could correct, somehow, over time.”

Living up to his Dr. Doom title, he soon upgraded that correction call: “This might lead to a generalized credit and equity and asset bubble in the next year or two, followed by a crash.”

Sowing Seeds of Turmoil

The reason Roubini upgrades his call for a correction to a crash is because of bubbles being blown into that sweet chocolate milk that investors just can’t get enough of: yield.

“With interest rates on government bonds in the US, Japan, the United Kingdom, Germany, and Switzerland at ridiculously low levels, investors are on a global quest for yield,” Roubini explains in an opinion piece for Project Syndicate.

Prior to the recent ultra low interest rates, investors could get some pretty decent yields from bonds, both government and corporate. But with all the bond buying central banks have been doing lately, bond prices have risen and yields have been squeezed. The thirst for a decent yield is pushing investors to take on more risk than they would have otherwise, and in many cases more risk than they are fully aware of.

“The problem is that the Fed’s liquidity injections are not creating credit for the real economy, but rather boosting leverage and risk-taking in financial markets,” Roubini explains in his article. “The issuance of risky junk bonds under loose covenants and with excessively low interest rates is increasing; the stock market is reaching new highs, despite the growth slowdown; and money is flowing to high-yielding emerging markets.”

Because the base interest rates are low, junk bond issuers are finding they can raise capital for dirt cheap interest payments, meaning that investors are now taking on much more risk than they are being compensated for through yield. And this is driving other investors into equities at a greater rate than they would otherwise be invested, further fueling the equity run.

“The reality is that credit and asset/equity bubbles are likely to form in the next two years, owing to loose US monetary policy,” Roubini drives the point home. Central banks are raising cubs that will ultimately grow into ravenous bears.

Will History Repeat?

Similar moves by the U.S. Federal Reserve over the past dozen years or so are leading Roubini to consider central banks as being stuck between a rock and a hard place with no way out. All this stimulus has raised an issue that even other economists besides Roubini have become increasingly weary of: how in the world will the Fed unwind this one?

At some point, interest rates will have to rise and “normalize” at a level that keeps the economy humming along at a sustainable pace, kind of like pulling back on the accelerator pedal to the halfway point, so you are not driving too fast to break the speed limit nor driving too slow to cause crashes behind you.

Roubini and other economists fear that by the time the U.S. economy reaches the targets the Federal Reserve is looking for (unemployment at 6.5% and inflation at 2-2.5%), interest rates will have been so low for so long that unwinding all this loose credit will be impossible without triggering serious implosions of all these bubbles that are currently growing everywhere from bonds to equities.

“Even when the Fed starts to raise interest rates (some time in 2015),” explains Roubini, “it will proceed slowly. In the previous tightening cycle, which began in 2004, it took the Fed two years to normalize the policy rate. This time, the unemployment rate and household and government debt are much higher. Rapid normalization – like that undertaken in the space of a year in 1994 – would crash asset markets and risk leading to a hard economic landing.”

Drawing on the recent past, a rapid raising of interest rates would choke an economy not yet fully recovered even by then, resulting in the popping of one asset bubble after another.

On the flip side, a slow normalization of interest rates would have to be extremely slow given the worse employment and debt (both family and government) situations of today. “Last time, interest rates were too low for too long (2001-2004), and the subsequent rate normalization was too slow, inflating huge bubbles in credit, housing, and equity markets. We know how that movie ended, and we may be poised for a sequel,” Roubini warns.

Either way, no matter how the Fed chooses to unwind all this stimulus and start taking money back out of the system, whether quickly or slowly, the aftershocks to the system will be dire, opines Roubini.

“If financial markets are already frothy now [all the bubbles blown into the chocolate milk by the Fed’s stimulus], consider how frothy they will be in 2015, when the Fed starts tightening, and in 2017 (if not later), when the Fed finishes tightening?” Roubini stresses.

“The exit from the Fed’s QE and zero-interest-rate policies will be treacherous,” Dr. Doom foresees. “Exiting too fast will crash the real economy, while exiting too slowly will first create a huge bubble and then crash the financial system. If the exit cannot be navigated successfully, a dovish Fed is more likely to blow bubbles.”

Investing Amid the Bubbles

Walking through a crowded room where everyone is happily blowing soap bubbles in your face is pretty tricky, as your vision can quickly become distorted.

Your instinct is to avoid the bubbles. And that is famed stock investor Warren Buffett’s advice.

In an interview on CNBC earlier this week, Buffett warned that bonds are “terrible investments right now.” He went on to say, “Bonds are priced artificially, you’ve got some guy buying $85 billion a month, and that will change at some point. And when it changes, people could lose a lot of money if they’re in long-term bonds.”

Although Buffett may not be as gloomy on the future of equities as Roubini, Warren does agree that bond prices are being kept artificially high due to Federal Reserve purchases. Always with a preference for stocks, Buffett sees equities as the only place to be now.

But even so, he is not one to buy willy-nilly, even in a rising market. At some point the tide will stop rising and even fall for a time. When the tide turns, investors will want to be holding companies that can stay afloat on their own without any assistance from general market sentiment.

Scrolling through the list of companies held by Buffett’s investment company Berkshire Hathaway Inc. (NYSE: BRK-A), one finds a consistent pattern in the companies that fit Buffet’s criteria: they are in demand in all economic cycles, have popular well-recognized brands, and plenty of cash steadily coming in.

Solid fundamentals. There are no bubbles in Buffett’s chocolate milk.

Joseph Cafariello

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