Bubbles

Last Winter, the financial markets expected an economic slowdown sometime late this year or early in 1996. The slowdown appeared before daffodils; in May Alan Greenspan acknowledged a "significant risk of recession."

A short ninety days later, the slowdown has come and gone, and the ghoulish bond market is worried that a rebound may already be underway. All interest rates are higher now than at any time since April.

We've had narrower escapes, but none quicker. Where did the recession go?

For a recession to develop, let alone be severe, there must be some economic over-extension, over-confidence, or extreme distortion -- a bubble of some kind. Though the economy was growing too fast last year, there was no bubble present. Except, of course, for the stock market.

In the 1950's and 1960's, in an economy dominated by manufacturing, recessions were distinguished by inventory bubbles. In a hot economy, merchants would get too excited about future sales and order too many Edsels and Hula Hoops. When the Fed put on the brakes, and demand fell, orders stopped until overstocks were sold. No new orders meant layoffs among producers, which meant even lower demand until the Fed eased.

Beginning in the 1970's, a combination of a growing service sector (carrying no "goods" at all) and "just in time" inventory management reduced the role of inventories in recessions.

The 1973-4 recession defined the new model. The first of the real estate bubbles burst, we had the first big devaluation of the dollar (anybody remember gold at $35/oz.?), and the first "oil shock," when prices soared from $2.50/bbl to $12/bbl. Multiple bubble, bad recession.

1979-82 was an oil shock replay, as prices went from $12/bbl to $38/bbl, which pressurized the inflation bubble of the century. CPI rose 13.5% in 1980 alone (anybody remember gold at $800/oz.?).

The 1989-90 dip was short and mild, and the bubble correspondingly minor. A commercial real estate bust wiped out lot of bank capital, but the recession was fatal only for George Bush.

Whatever slowdown we had in the Spring of '95 is either over, or can be contained with more easing by the Fed. Unless some surprise bubble were to blow. Like the stock market.

It's fun to tease fans of the stock market, whether gung-ho investors, brokers, or the cheerleading financial press. They so often mask nervousness with analytical fervor that a loud noise behind them tends to get a wonderful reaction. However, as much fun as it is, I can't make a case that the stock market poses an immediate hazard to the economy, nor reward the Chicken Littles who every year see the stock market as the bubble of the decade.

The stock market's current condition is a bubble. There are only two ways to make money from stocks: dividends, and higher stock prices. The current dividend return from stocks is less than half the T-bill rate, and at a low which has announced every previous crash. Therefore, these high stock prices are based on an expectation of even higher prices.

This condition would be nuts if the flood of new investment dollars were not so likely to continue. Two billion new dollars flow into mutual funds each week.

The crucial, sustaining source of gas for this bubble appears to be the Baby Boomers. The Boomers have caught sight of retirement, expect nothing from Social Security, and have become compulsive about saving. They don't save at banks, like their parents; they save in mutual funds.

The new money going into mutual funds is not in a frothy search for yield; it's driven by a frantic search for security -- that's why it doesn't leave the market after a bad day, or year, as we learned in 1987, 1990, and 1994. Dangerous bubbles grow when players expect to win, big and fast. The Boomers are saving because they have to.

In the long run, this flow of equity capital may produce an economy so strong and sound that corporate earnings and dividends will justify astronomical stock prices.

I sure hope so, though there is one, small weak spot in the bubble. What happens when the Boomers begin to retire, stop investing, and start cashing out?