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Generational Dynamics Web Log for 10-Nov-06
As stock market bubble skyrockets, risk premiums are collapsing

Web Log - November, 2006

As stock market bubble skyrockets, risk premiums are collapsing

Desperate investors appear willing to take any risk these days to get returns.

And the way we know that is because of the collapse, this past week, in the price of "credit default swap" (CDS) derivative instruments.

We'll take a moment to explain what this means.

"Derivatives" are investments that allow you to make "bets" that something will or won't happen. For example, if you want to bet that winter will be especially cold, you can purchase a weather derivative based on energy stocks. If winter is cold, then the energy stocks will go up, and the weather derivative will go up. So buying the weather derivative lets you bet that the weather will be cold.

Hedge funds often make multiple investments, so that a loss in one investment will be hedged by a gain in another investment. For example, if you invest in retail stocks in the Christmas season, and you're afraid you'll lose money because the weather will be too cold and people won't go shopping, then you can also buy the above weather derivative as a hedge. If you structure it very, very cleverly, then you'll make money if the weather is cold or not.

Another investment you can make is that you can buy corporate debt or corporate bonds, essentially making a loan to a corporation. But what if the corporation defaults or goes bankrupt? Then you would lose your entire investment.

So you take out some insurance. You make a second investment, in "credit default swap" (CDS) derivatives. If lose money in the first investment, then the second investment will pay off. Once again, you have to be very, very, very clever to make sure that you'll make money no matter what happens.

Well, what's happened in the last two weeks is that investors have stopped buying CDSs, and so the price of CDSs has collapsed, falling more than 16%. And for hedge fund firms that own these CDSs, there's "panic selling" going on, as the CDSs fall in value.

Why would investors stop buying CDSs? Apparently it's because they don't believe there's anything to be afraid of. They're certain that corporations will be able to repay their debts. What's the point of buying fire insurance if you're sure that your house won't burn down?

Another possibility is that investors are desperate. If you think you're going to lose your house anyway, you might not bother with fire insurance. If you think you might go bankrupt anyway, you might gamble on a risky investment without buying any insurance.

Either way, investors are suddenly becoming more risk-seeking, and less risk-averse.

There's an easier way to see that investors are suddenly becoming more risk-seeking.

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 3-Nov-2006. <font size=-2>(Source: MarketGauge ® by DataView, LLC)</font>

S&P 500 Price/Earnings ratio and S&P 500-stock Index as of 3-Nov-2006. (Source: MarketGauge ® by DataView, LLC)

The above graphic is the November 3 version of the graphic that appears on the bottom of the home page for this web site. It shows the price/earnings ratio index for the S&P 500.

As the graphic shows, investors have been getting increasingly risk-averse for the last few years, but in the last couple of weeks the index suddenly began to increase.

Thus, investors are willing to pay more for stocks with the same corporate earnings.

Both the increasing price/earnings ratios and the collapse of CDS prices indicate the same thing: That investors are again becoming risk-seeking, and are pushing the stock market bubble up even higher.

With the derivatives market soaring and almost completely unregulated, global finance is getting crazier and crazier almost every day. Consider these figures:

The derivatives market has reached nearly $300 trillion in value.

The total value of the stock and bond markets is only $65 trillion.

How do you suppose it's possible for $300 trillion of derivatives to be based on just $65 trillion of underlying stocks and bonds? Well, that's how a bubble works. The derivatives instruments are sold and resold, sometimes to the same people. Each selling raises the price of the instrument. If anyone else were doing this, it would be called an illegal pyramid scheme.

Derivatives and hedge funds have grown explosively in the last five years, and credit derivatives (like CDSs) have been the fastest growing type of derivative. Financial firms have created so many different kinds of derivatives, allowing investors to "bet" on so many different things, that regulators don't even understand all the kinds, let alone keep track of all the firms offering them. And incidentally of the 10,000 or more hedge funds available today, 8,000 are registered in the Cayman Islands. Many officials are increasingly calling them "weapons of mass financial destruction."

Generational Dynamics has been predicting since 2002 that we're entering a new 1930s style Great Depression, with a stock market crash most likely by the 2006-2007 time frame. This could happen next week, next month, next year or after that, but explosion of derivatives and the decrease in risk-averseness of investors is making the global financial structure increasingly unstable. (10-Nov-06) Permanent Link
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Generational Dynamics Web Log for 10-Nov-06 As stock market bubble skyrockets, risk premiums are collapsing

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Generational Dynamics Web Log for 10-Nov-06
As stock market bubble skyrockets, risk premiums are collapsing