Exuberance Compounded

A stock market in full, speculative flood is a risky affair, but the risk is mostly confined to the speculators themselves, and does not extend to the economy as a whole.

National myth holds the Crash of '29 as the cause of the following Great Depression, but myth has it backwards: the Crash was really just the first of the Depression symptoms. (The real cause? In sequence, Versailles, war reparations, gold standard, Smoot-Hawley tariff, and then a terrible contraction in world trade.)

It's possible that a bad "correction", a mini-crash, or a 30% real thing could do harm to the whole economy, but not likely, not this time. There is no evidence whatever of liquidation of investments in other markets to supply more cash to buy stocks, nor evidence of more dangerous, leveraged speculation in stocks. There is a parade of financial statements passing through my office, and I have yet to see a single person fooling around in the stock market with borrowed money.

Nope, we're fooling around with real money: savings earmarked for retirement. Or, aging Baby Boomers that so many of us are, savings for tuition for kids who will go to college when we areÉ well, in my case, I'll be 63 when Gus starts college.

It's real money, and we're running out of really good places to invest it. Many prudent people slowed or stopped their stock market investment last winter, and began to buy "safe" stuff, like bonds. This shift has led to the irrational exuberance phenomenon for 1997: the bond market has gone just as nuts as the stock market.

How do you measure speculative excess in bonds? Investors get carried away chasing the highest yield, and forget that high yield corresponds to high risk. Last winter, junk bonds became the first darlings of the safety switchers. The junk-to-Treasury spread is usually 4.00% or more, but hungry buyers have driven it to 2.00% or lower. This spring, yield hogs bought corporate bonds so heavily that their usual 1.10%-.60% spreads over Treasurys fell to only .30%.

Credit quality aside, time is another element of risk. In the last four weeks, investors in Treasurys themselves have lost all fear of the future. T-bonds pay 6.75%, and one year T-bills pay 5.65%: 1.10% for 29 years' additional risk.

All right, so what? When the bond bubble breaks, some people lose some money, or a lot, and life goes on, just like stocks, right?

No. Not at all. Unlike the stock market, the bond market has a direct and powerful effect on the whole economy. Exuberance in bonds means easy credit, for everybody, immediately.

If it's easy to sell bonds, rates are low, and underwriting is easy. Every modern form of consumer debt -- car loans, mortgages, second mortgages, credit card balances -- has been reduced to bond form, and sold into a ravenous market, cheap.

How loose are the loan approval requirements? Everybody has heard the stories of credit cards mailed to children. My favorite sign of excess: in the last year, home equity lines of credit have become easily available up to 125% of the market value of the house. Idiots making loans to idiots.

While everyone is watching the job market for wage inflation, easy credit may soon produce a leveraged surprise in traditional, but forgotten places for inflation: tangible goods, commodities, and real estate. Stocks aren't going up on leverage, but there are a lot of other things out there to buy with 10% -- or nothing -- down.

I don't envy the Fed, here. They declined to tighten this week, and maybe that was the right thing to do. The Fed could cool off our investment ardor by raising rates, but wiping out our retirement savings in a market crash is hardly a solution. However, the Fed ought to be using all its regulatory power to tighten credit standards.