Is the private equity bubble the last of the red hot bubbles?  I wouldn’t be surprised.  After having lived with over 25 years of stock, dollar, real estate, Internet, and many other bubbles, we may have seen the last of the bubbles in the great Age of Excess.  Of course, there will be a few bubbles created by the collapse of the current set of  bubbles, primarily the gold bubble, but I think the private equity bubble represents the end of the current line of bubbles.

With over 40 deals having been pulled due to lack of demand for their debt in the last two months, there is clearly some real problems with the private equity market.  At least $200 billion worth of deals is waiting to be funded.  It’s not a good situation. Some Wall Street observers have said that there is currently no significant market for new deals.  The only activity is in funding previously announced deals. 

Is this just a temporary reprieve in private equity’s upward march?  Perhaps in another time it might have been.   But, given the other bubbles lurking on the sidelines–the real estate bubble, especially with the sub-prime wolf on the prowl, the dollar bubble that is losing air fast and the overall stock market bubble, it is unlikely that private equity will be able to resurrect the bubble fever of before.  Of course, more deals will be done, but the huge boost they gave to the stock market is likely gone.

Although the private equity bubble was short and sweet, it was very important in offsetting, for a while, the bad news hitting the market from the economy and the housing market.  Of course, it more than just offset the bad news and instead propelled the market to new highs—up 25% in a year—not bad at all. 

This also makes the market more vulnerable to a dramatic fall than it otherwise would have been.  Although a dramatic fall of 500 – 1000 points in one day may not happen, fall the market will without the buoyancy given it by the private equity bubble. 

If it is the last of the bubbles of the Age of Excess, what a way for the Age to end!  With hedge fund managers and private equity lords making a billion dollars in a single year.  With $25 million birthday parties and the highest real estate prices Manhattan has ever seen, sometimes doubling from sky high prices to stratospheric prices in only 18 months—it is the big blowout party to end all parties.  And, that may be exactly what it turns out to be–the end of the party.  And, if that happens, how appropriate it is that the bursting of the Private Equity Bubble marks the end of the Age of Excess.

Market analysts are very good at predicting how companies and markets will perform if not much change happens.  They are also good at predicting very short term movements.  If a company announces that it sees its earnings falling in the next quarter, analysts will take note and downgrade the stock.  However, if a company or an industry is in a great state of change, such as housing, they aren’t very good at analyzing companies.  This is why we will see very large and unexpected declines in mortgage or homebuilding stocks.  The analysts didn’t foresee the events that drove the prices down—whether it be a write- down in the value of a home, land holdings, a write-down in the value of a mortgage portfolio, or a downturn in sales.  The analysts couldn’t see these events and, hence, the very large unexpected decline in the stock price.

Of course, once the analysts see the events happen, they are quick to downgrade the stock.  But, future events are still a mystery to them.

Also, most analysts are good at analyzing that a stock will go up.  During the Internet boom, 97% of analysts’ stock recommendations were to hold or buy.  And, that was true when the market crashed. They weren’t very good at predicting that.  Although, the numbers are less today, analysts still have buy or hold ratings on over 90% of stocks.  Ultimately, all of this means that market analysts aren’t really analysts, they are cheerleaders.  They can’t really see the problems within a stock and to an even greater degree, they can’t see the problems in the stock market, in part, maybe because they don’t want to. 

I would contend that many money managers think a lot like stock analysts.  Not that they follow the advice of stock analysts, but that they think the same way.  Essentially, they are cheerleaders as well.

If this is true, then current market volatility is caused by false hopes.  As I have mentioned before, false hopes keep a bubble stock market alive.  In fact, short term, false hopes can be stronger than real hopes.

False hopes are stridently defended when the market supports it and incredibly quickly abandoned when the market does not.  There is no real convection to their belief in the market.  There is no real rational analysis behind it—just cheerleading

I think this is why we will see a lot of crazy movement in the market over the next few months.  When people are basing their investment decisions on false hopes, they will not hold them with the same conviction and will move with the pack.  Hence, when they see the market falling, they will tend to run for e exits.  When they see it rising, they will jump in so they don’t miss out.  It seems crazy until you realize they haven’t done their analysis or homework and are mostly holding onto false hopes which will inevitably meet the test of reality.

If  I was to sum up the mantra of the last 25 years of investing, that would be it. 
The idea is that as long as you do what everybody else is doing, invest in the stock market when everybody else is, invest in real estate when everybody else is, make investments that everybody feels are safe and socially acceptable, and you will do well.  In fact, you would do very well.  Very well indeed.  The returns to such safe, simple investments have been nothing short of extraordinary. 

However, any sensible financial historian will tell you that extraordinary investment returns are made because someone did something extraordinary.  They invested in the telephone, even though everyone else, including Western Union, thought it didn’t make any sense.  They also took a great deal of risk and put in an extraordinary amount of creativity to make sure that the investment worked. 

But things changed in the last 25 years.  You could double the value of your home just by watching TV for three years.  No improvements, no great real estate investment insight.  Just sit in your home and watch the price soar each year.

You could put your money in a well respected and established stock mutual fund investing in blue chip stocks.  Take little risk, put in no time or thought and see your money increase 1000% in 20 years. You could push a little toward the higher risk end of stocks - a diversified NASDAQ stock portfolio and see your investment rise 2500% in 20 years. 

There’s never been anything like it before in US history.  It was truly an amazing time.  You could invest like an idiot—just do whatever everybody else did–and make returns like an investment genius.

Of course, as our book says, this amazing time will soon come to an end.  But, this mentality that someone can invest like an idiot and make money like a genius will hurt us for decades to come.  It is not the basis for growing an economy.  It is part of what some people call a sense of entitlement that pervades much of American society today. 

It will also make it difficult for individuals to make money.  They will want to invest like idiots and expect to make returns like geniuses.  This won’t happen anymore.

They will have to do highly unusual things to make money that most people won’t do.  They’ll have to get out of real estate early.  They’ll need to get into gold—a very unloved investment right now.  They’ll need to bet against the dollar.  Some will need to get involved in corporate turnarounds—but not too soon or they will get burned because they acted before the economy or that industry hit bottom. 

It will be a very tricky and difficult time for people who want to invest like idiots.  For people who want to invest the old-fashioned way, there is plenty of opportunity.  But the old-fashioned ways of moving into unloved investments that made good financial sense and putting in a lot of creativity to make them work are long gone.  Few remember them. 

I suspect many great investors will go down with the idiots as well.  As much as I respect Warren Buffet, I sense he may not move quickly enough to avoid problems.  On the other hand, I sense George Soros may be just the right person for these future markets.  But, who knows.  All I know is that the current ways won’t work, and people will be very reluctant to bring back the old-fashioned ways once they have been spoiled by investing like an idiot and making returns like a genius.

It seems so simple and almost not worth repeating, but it is so important to understanding what is going on in the current economy.  And, it is something that almost all economic and financial observers are missing. 

The housing, stock and dollar markets really are bubbles and to truly understand how these markets will evolve in the next few months and years, you have to understand that point.  To look at them as normal non-bubble markets guarantees your predictions and financial analysis will be wrong because they will be based on the wrong assumptions.

Looking at the housing market as simply having a setback in its normal 10 to 20% annual price increases due to sub-prime problems or that price growth will simply slow down to 5% or so in the next few years due to too much housing supply, misses the key factor driving home prices.  That factor is that the market wasn’t driven by economic fundamentals, it was driven by bubble economics, as explained in the book.. 

And when that bubble stops being inflated, it will pop.  It won’t just modify its growth curve or take a temporary breather—it will pop.  Exactly how it will pop is impossible to predict other than it will likely happen in two parts—the first part happening very slowly, and the second part very fast, just as the book explains.

The same is true with the stock market.  It will not simply readjust its inexorable growth to a Dow of 36,000, it will pop.  The movement in the stock market over the last 25 years wasn’t driven by economic fundamentals.  As Nobel prize winning economist, Milton Friedman, has often pointed out, the long term economic fundamental for earnings growth and, hence, stock market growth, is growth in the economy.  Our economy hasn’t grown 1300% in the last 25 years, but our stock market sure has.  It’s a bubble.  It’s not fundamental economic forces that are propelling it. 

The forces that are propelling the bubble are well explained in the book.  To look at it as a normal stock market that is not a bubble is to completely misunderstand what is going on.  Any analysis that is not based on the knowledge that it is a bubble stock market will ultimately be wrong.  Hence, most other economic and financial observations of the market are wrong.

How economic and financial analysts can keep missing this point all the time still amazes me.  But, hope springs eternal, even if it is false hope.  In fact, false hope seems much more powerful than real hope in the short term. 

Analysts are not so sanguine on the dollar, because it just keeps falling.  But there is the same false assumption that somehow it will stop falling.  No one says it outright, but most economic and financial analyses of our economy and our stock market are not made with the assumption that the dollar will continue to fall a whole lot more.  Any analysis that does not assume a dramatically falling dollar will be wrong.  It really is a dollar bubble, as the book explains.  Hence, you have to analyze the dollar and its impact on the economy and stock market differently than with a regular market. 

Most importantly, you have to understand that there are multiple bubbles, such as the ones just explained and that they will all interact with each other.  If you don’t see the dollar or housing bubbles popping and their effect on the stock market bubble, then you aren’t seeing economic reality and hence, your economic and financial analysis will be flawed. 

Not seeing that these markets are bubble markets might seem a simple mistake.  But, it is the most fundamental mistake of all.

When I read various analyses of the housing market, the discussion often focuses on the idea that the current housing problem is just a matter of excess supply of both new and used homes that will just have to be worked off. At that point, prices will turn around.  Of course, this analysis doesn’t ask the more fundamental question of why supply and demand turned around so quickly and created such excess supply. 

Excess supply is a symptom of the problem, not the cause of the problem.  If you don’t look deeper at the causes, you’ll misunderstand what is going on in the housing market and be wrong in your predictions of a turnaround.

What is going on is the bursting of a housing bubble.  The high prices of the last few years weren’t driven by economic fundamentals and hence, the prices will not return to their bubble levels.  Rather, what will happen is that as prices go down, people will lose their primary motivation for paying high prices for homes: making money on home price appreciation. 

In understanding the housing market, it is important to differentiate between paying high prices for homes and paying for homes.    People need homes and they will continue to buy homes.  That doesn’t mean people will pay high prices for homes.   So, when we say the housing market won’t turn around, we mean it won’t turn around at anything like the current prices.  Prices will have to drop a lot—a whole lot to sell the excess inventory.

The problem with dropping prices in the home market is that the usual rules of price elasticity don’t apply in the short term.  Normally, if you drop the price of a good, demand will increase.  Unfortunately, if you drop the price of a home, demand will ultimately decrease because people are worried they will lose money if they buy a home.  And, given that the equity may be only 10% of the value of the home, they could easily lose ALL of their money.  Buyers become afraid to buy. 

Unfortunately, this ultimately creates “seller panic” as home sellers find it harder and harder to sell their homes and ultimately, those that have to sell, start lowering their home prices a lot to sell them for what they can get rather than keep holding them off the market for a higher price.

The problem with “seller panic” is that it creates “buyer panic.”  Although some buyers buy the homes at the lower prices, other buyers see prices going down rapidly and get very afraid to buy a home.  They don’t buy even with drastically lower prices.

We need to add to all of the above problems a key underlying problem–the increasing lack of easy financing due to the losses the mortgage lenders are taking.  In addition, interest rates are rising due to rising long term interest rates worldwide and an increase in the risk premium demanded by investors for what is now perceived to be a riskier investment.  All of this adds up to severe downward price pressure on housing.

And, there is an unseen party spoiler coming down the pike—down payments.  Down payments in many cases have gone to zero.  That will clearly end soon even for buyers with A+ credit ratings.  That in itself will take a lot of people out of the housing market.  However, longer term, as prices continue to fall, banks will be forced to revert back to previous practice of requiring 10 – 20% down payments from everyone.  When home prices are falling 10%, 20% or more, banks will need at least 10% and probably 20% to protect themselves against losses.  That’s part of the reason down payments were required in the past.  It wasn’t assumed in the past that home prices always go up and there is a significant cost to foreclosures.  Once home prices are no longer assumed to go up, but proven to fall significantly, banks need the old protection they had before.

Down payments of 20% or more will make it very difficult for many people to buy a home.  Plus, it’s just another hurdle to get a buyer through to make a sale, even if they have the money for the down payment.

Add another problem, the foreclosure of almost 2 million homes this year, when we are only selling 6 million homes and you get enormous downward pressure on home prices.

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Finally, add job insecurity from an economy that has been pushed into a mild recession by the downturn in housing and home equity related consumer spending, and you have a recipe for big home price decreases.

Although this may sound pessimistic, as I said in the title, I am not pessimistic on the housing market.  I am simply not so optimistic to believe that home prices can double when incomes only go up 5%.  It just doesn’t make economic sense.  Everyone else is incredibly optimistic to believe that.  But, although  I’m no pessimist, I do know what happens when you get too optimistic and prices go up well beyond their economically sustainable levels.  They will go back down to their economically sustainable levels, which is not only were they began before the bubble, but it is where they will be after the credit market and people’s confidence in the housing market has been rocked to its core by the collapse of the market after an overly optimistic group of buyers faces reality.

Those prices are much lower than they were in 2001.  That’s not pessimism, but it’s not incredibly optimistic either.  It’s just reality.