Editor's Note

05/03/2007 12:00 am EST

Focus:

Howard Gold

Founder & President, GoldenEgg Investing

May 3, 2007

As the Dow Jones Industrial Average sets new records and the Standard & Poor’s 500 is within a stone’s throw of its all-time high, it looks like nothing but blue skies for stocks. So, where might the clouds come from?

Now I’m bullish about the markets, large US growth stocks in particular, as I’ve written here before. Strong earnings, decent economic data, and powerful liquidity should keep the bull running for a while—in most of the world.

Yet in the last couple of weeks we’ve seen some hints of what could derail this freight train.

A page-one story in Monday’s Wall Street Journal (“As Funds Leverage Up, Fears of Reckoning Rise,” subscription required) discussed the outsized role leverage plays in today’s financial markets.

“We’re living on planet leverage, and regulators and market gurus are getting nervous,” the Journal reported.

Total leverage in the financial markets (by big investment firms, hedge funds, and individuals) approached $5 trillion last year, nearly triple its amount in 2002, before the bull market began.

Advanced computer technology and the sheer volume of money around has encouraged Wall Street firms to create ever-more exotic derivatives that allow traders and sophisticated investors to bet on every possible outcome of a transaction. 

And increasingly investors have used leverage to boost returns. Big Wall Street firms have assets worth a whopping 25 times their shareholders’ equity. Margin debt for individual investors now tops the levels it reached during the dot.com boom.

Even more troubling is the lack of transparency. With so much money in the hands of hedge funds and private equity firms that don’t disclose much about what they’re doing, we don’t know how much is really at risk and where those risks lie.

This is giving regulators nightmares. Financial panics often start with marginal instruments in remote locations (like the Thai baht in 1997) and then spread rapidly as traders sell more mainstream offerings (like good old stocks and bonds) to raise cash quickly.  

There are two bubbles in the world—one already bursting, one still growing—that are the kinds of places where a financial crisis can begin. (I’m not saying it’s going to happen, just showing how it could.) One is Spanish real estate; the other, of course, is mainland Chinese stocks.

No longer the dreary backwater it was under Generalissimo Franco (yes, he’s still dead, as the old joke goes), Spain has emerged as the Iberian Tiger, one of Europe’s fastest growing economies. Its stock market topped all developed markets last year, with a 50% return. And by the way, the wine is terrific.

Its real estate market has been on fire. Housing prices have posted double-digit percentage gains for the past decade. Some 85% of Spaniards own their own homes, the highest such rate in western Europe.

But they did it the good old American way, by piling on debt. Household debt now sits at more than 120% of disposable income and a stunning 95% of mortgages carry adjustable rates.

So, as the European Central Bank raises interest rates to cool the continent’s hot economic growth, the other boot is dropping. Last week fears of a real estate crash sent stocks of Spanish developers and construction companies plummeting. While other world markets rally, Madrid’s blue-chip Ibex 35 is about 5% below its recent peak. And it could get worse.

“’Spain is going to face a cycle of recession, deflation, and widespread private sector default—a depression in fact,’” Bernard Connolly, global strategist for Banque AIG told the Daily Telegraph of London last week. “’This stock market slide is not just a correction. It has a very, very long way to go.’”

So far the rain in Spain hasn’t spread much beyond the plain, and I don’t think too many investors are placing leveraged bets there. But we should keep watching to see if Europe’s fourth largest economy becomes the canary in the coalmine.

One place where there’s certainly too much hot money is mainland China.  In February I wrote that China showed all the signs of a mania, like tulip bulbs or dot.com stocks.

The next week the Shanghai Composite index plunged nearly 9% in one day, taking most of the world’s markets down with it. But it has since skyrocketed some 40% from its lows as ordinary Chinese pour their savings into newly minted mutual funds and shares of Chinese companies.

As small investors pile in, the big institutions are trimming their sails. Last week Gao Xiqing, who manages China’s social security fund, says he’s cutting his exposure to mainland Chinese stocks, declaring: “This market seems to be defying gravity. It’s got to come down at some point. The market is making me nervous.”

Mr. Gao thus becomes the latest in a long procession of government officials who’ve cautioned the masses about the animal spirits that move markets. Certainly no one in China can say they weren’t warned.

Will the next selloff in China be deeper than February’s and will it take the global bull market with it? Possibly, but who can say?

I wouldn’t sell most stocks now, but I wouldn’t load up on them, either. I would use big up moves in the market to take profits in overvalued assets like emerging markets, high-yield bonds, and domestic REITs.
 
As I said, this bull can keep going for a while. But I keep thinking about something Mao Zedong (who must be spinning in his grave at China’s love affair with capitalism) once said: A single spark can start a prairie fire. And leverage is the oxygen that could help it spread.

Comments? Please email us at TopProsTopPicks@intershow.com.

Howard R. Gold is editor in chief of MoneyShow.com. The views in this commentary are his own and don’t necessarily reflect those of InterShow.

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