12/03/2013 06:01 PM

Feeding the Bubble

Is the Next Crash Brewing?

By Martin Hesse and Anne Seith

Twitter executives and founders at the New York Stock Exchange on Nov. 7 clap as their company launches its initial public offering.
Twitter executives and founders at the New York Stock Exchange on Nov. 7 clap as their company launches its initial public offering.

Central banks around the world are pumping trillions into the economy. The goal is to stimulate growth, but their actions are also driving up prices in the real estate and equities markets. The question is no longer whether there will be a crash, but when.

When 42-year-old hedge fund manager Mark Spitznagel wants to forget about his high-stakes business for a while, he heads to the goat farm he and his wife Amy purchased in the bucolic hills of Michigan. There, he produces cheese according to environmentally sustainable methods, because he views modern agriculture, with its large-scale pesticide use and automated factory farms, as degenerate. In fact, he says, factory farming is "an ideal metaphor" for the economy.

In Spitznagel's view, the world's financial and equities markets are also dysfunctional, and what happens there is unhealthy and anything but sustainable. As a money manager, he has also opted for an alternative business model of sorts: He's betting on a crash.

For his customers, Spitznagel's multi-billion-dollar fund acts as an insurance policy against the next meltdown in the financial system. When the market is doing well, they lose modest amounts of money. But they cash in as soon as prices take a nosedive, even when all other investments are going up in smoke.

The hedge fund manager has made a lot of money in the past with his prognoses, and he is convinced that substantial turbulence is on the cards for the near future. "The setup is there for it," says Spitznagel.

'It Might Go Badly'

Since the last crisis, central banks around the world have pumped trillions into the economic cycle, both by lowering interest rates and buying up securities in the markets. For central bankers like United States Federal Reserve Chairman Ben Bernanke, the aim of the policy was to stimulate the economy and rescue banks that could no longer raise capital elsewhere. But this "grand monetary experiment," as Spitznagel calls it, has side effects. Because it makes borrowing cheaper than even before and saving all but pointless, it encourages investors to pursue reckless deals. Share prices are exploding on stock exchanges around the world, while real estate prices are rising at an alarmingly fast pace. And many US companies are now in as much debt as they were before the financial crisis.

To take Spitznagel's metaphor a step further, the flood of money coming from central bankers acts like a highly aggressive, artificial fertilizer. It generates enormous yields in the short term, but eventually leads to potential devastation.

Graphic: The bloated value of publicly traded companies worldwide
Click here to enlarge graph

For this reason, the ongoing party in the stock and real estate markets is beginning to feel uncanny to a growing number of observers. "It might go badly," Nobel laureate Robert Shiller told SPIEGEL. Some economists are even convinced that the question is no longer whether the next crash is coming, but when.

Click here to enlarge graph

For brokers on the venerable trading floor at the New York Stock Exchange, such predictions are hugely exaggerated. "This is not a bubble," says Peter Tuchman, who has worked on Wall Street for almost 30 years and, with his white, Einstein-like hairstyle, half a dozen bracelets and well-worn running shoes, is a legend on the floor. He taps his smartphone a few times and pulls up a graph depicting the S&P 500 index of stock prices for 500 large companies, which has gone up by 166 percent since it hit rock-bottom in 2009. "This is a stable development," says Tuchman, pointing to the graph, which is directed uniformly upward. In his view, these are simply good times following on the heels of years of crisis. "There are new company listings every day," he says. "That is a good sign to me."

It's the first Thursday in November, the day of the Twitter IPO, and the jocular trader is completely in his element when a nine-year-old girl in a tulle dress and actor Patrick Stewart, who played Captain Jean-Luc Picard on the "Star Trek: The Next Generation" series, ring the traditional opening bell.

At 9:45 a.m., during the initial pricing phase, the Twitter share price jumps from $26 (€19) to more than $40. At 9:54 a.m., Twitter is trading at about $42 a share, and at 10:49 it's at $45.10. "If you bought the stock yesterday evening and sell it today, you'll have earned a return on investment of more than 70 percent," says one of Tuchman's fellow traders, with a note of awe in his voice.

Twitter hasn't made any money yet, nor does it have a convincing idea of how it will do so.

Other tech stocks are also doing extremely well, just as they were in the heyday of the New Economy. Amazon's share price has almost doubled in two years, while electric car manufacturer Tesla has gained 300 percent in market value in the same period.

"It is a complete joke," says hedge fund manager Spitznagel. He explains that the market is driven by investors' confidence that prices will continue to rise in the future. He says it is "a self-reinforcing process entirely disconnected from economic reality."

A Hunger for German Stocks

For many people, what Spitznagel is describing is typically American. In the heartland of capitalism, the crash has been to economic life what the Colt gun was to the Wild West. In Germany, on the other hand, centuries-old family businesses operating in brick-and-mortar factories make sophisticated tools, machines and systems, with which real, palpable, everyday products are made in the rest of the world. One would think that prices would be more down-to-earth in such a grounded environment.

Dürr AG, which makes machine tools in Germany's southwestern Swabia region, is one of those traditional companies. In business since 1895, Dürr is a supplier to automakers, as well as the chemical and aviation industry, and it manufactures production and environment technology systems -- a thoroughly solid product line.

But Dürr's share price has doubled within a year and increased fourfold in the last two years. A share of Dürr stock costs €66 today, whereas it could be had for less than €4 in 2009.

That's because international investors are hungry for securities like Dürr shares, which embody the successful model of Germany's export economy. It's also because companies like Dürr benefit from growth in emerging economies, and because their operations are in Germany and not in one of the crisis-ridden countries of the euro zone.

This demand has driven the MDAX, a German stock index for mid-sized companies, from 11,400 to 16,300 points within a year. The index is currently almost four times as high as it was during the stock market boom in 2000, far outperforming the DAX itself, an index of Germany's 30 largest companies -- although the DAX is also breaking one record after the next.

Germany is a hot commodity among investors, in both the equities and real estate markets. Prices for single-family homes and condominiums in major cities like Munich, Hamburg, Frankfurt and Cologne are rising faster than rents, a sign that speculators are pushing their way into the market. Buyers are from Germany, Italy, Eastern Europe and Asia, and they are buying German real estate because they believe that by investing in "concrete gold," they can protect themselves against the dangers of inflation.

This buying frenzy creates potential trouble spots around the world. Real estate prices in major Chinese cities have increased by more than 20 percent in only a year, wealthy foreigners are snapping up luxury property in Istanbul, and in the United Kingdom the government is giving an additional boost to the economy by offering a special loan program for homebuyers.

In the last 12 months, real estate prices in the United States have gone up more than they have since 2006. Some cities, like San Francisco and Las Vegas, have even seen price increases of 24 to 27 percent. Ironically, the last crisis began in the overheated US housing market.

'Ignoring the Risks'

Some economists seek to allay fears by noting that the real estate market still has a long way to go before it reaches the levels that triggered the last crash, and that prices are still averaging 50 percent lower than they were then. But who says that you have to reach the most inflated point in the last crisis before a dramatic downturn sets in? And at what point does a solid growth trend turn into unhealthy hype?

"There are two types of bubble," says economic historian Werner Abelshauser, "the classic and the modern type." The mother of all classic bubbles was the market euphoria that took hold in the United States in the 1920s and came to an abrupt end on Oct. 24, 1929, known as Black Thursday. 

"From maids to taxi drivers, people were intoxicated with the idea that an age of never-ending prosperity had begun. They bought refrigerators and cars, as well as stocks, frequently on credit," says Abelshauser.

Black Thursday was followed by a Black Monday and a Black Tuesday. Within a few days, the benchmark Dow Jones index had lost a third of its value.

In the late 1990s, with the advent of the Internet age, investors believed once again that new economic laws applied and that growth rates would continue to rise. The term "New Economy" was coined. Once again, people who barely knew what a share was began trading in the market, even scrambling to buy shares in companies with nothing more than a vague prospect of ever turning a profit.

The New Economy bubble burst when the first of these companies were unable to fulfill overinflated expectations, and when several cases of fraud came to light.

A Blind Eye to Excessive Hype

Even Abelshauser, a prudent man with gray hair and a somewhat skeptical look in his eyes, lost money in the stock market at the time. What fascinates Abelshauser even more than the phenomenon of a bull market propelled by milkmaids and dentists is the second type of speculative bubble: one based on the new methods of financial mathematics, and the mad belief that risks can be largely overcome with sophisticated financial products.

The first such crash occurred in 1987, as a result of misguided speculation in financial derivatives, followed by a second crash in 2008. This time the culprits were banks, which had sugarcoated the numbers on subprime mortgage loans and sold them in large numbers.

Instead of eliminating investment risk, the modern mathematical models only increased investors' willingness to take risks, causing them to turn a blind eye to excessive hype.

Another phenomenon has also been around since the 1970s: debt management policy. After the oil shocks and the economic crisis they triggered, governments tried to jump-start their economies by borrowing and spending more. "The more money that is injected into the economic cycle, the more room there is for speculative bubbles," says Abelshauser.

Today central banks, especially, have encouraged the flow of capital with their extremely low benchmark interest rates and financial bailouts for banks and governments.

But the situation becomes dangerous when even the massive sums central banks are pumping in the economy don't lead to a rise in consumption and corporate investment. Economists like Carl Christian von Weizsäcker of the Max Planck Institute for Research on Collective Goods in Bonn, Germany see evidence of a global investment bottleneck, noting that too few factories are being built and not enough new products developed. This is offset by the growing mountain of savings aging Western societies are accumulating as a safeguard for the future.

Exacerbating a Problem

It's a misguided approach, though. The consequence of a high savings rate and a low investment is a decline in interest rates

Insurance companies and pension funds come under great pressure to invest their customers' assets in ways that are at least somewhat profitable. The flood of money coming from central banks only exacerbates the problem.

Central bankers claim they will be able to use the tools of monetary policy to extract the money from the global economy once again -- at just the right time and in the right amounts. At times, it almost sounds as if they were the ones who were trying to use numbers to obscure the risks.

But the danger is real, and the only question is how far prices on financial markets have already strayed from fundamental values.

The problem is that every expert comes up with a different answer. "It is a bit tricky," Nathan Sheets, global head of international economics for US-based Citigroup, says of the situation in bond markets. Low interest rates make borrowing cheaper than ever. US companies alone, by issuing bonds to willing investors, have borrowed money at a faster pace this year than ever before. If central banks decided to stem the flow of money, painful corrections could ensue.

Sheets is less concerned about prices on US stock markets. "There are a large number of firms that are extremely profitable and internationally competitive, with strong balance sheets," he says.

Concerns over the Bull Market

Hedge fund manager Spitznagel, for his part, cites a simple indicator to substantiate his concerns over the bull market: Tobin's Q, named after its inventor, Nobel laureate James Tobin. Roughly speaking, Tobin's Q indicates how high a company's market value is in comparison to all of its assets.

Instances when this ratio has been high in the past have always been followed by a crash at some point, says Spitznagel. Tobin's Q is now extremely high in the United States.

In many places, it has become difficult to cite corporate profits as justification for rapidly rising share prices. This doesn't just apply in the glamorous world of US technology stocks, but also in the rock-solid Mittelstand, the term used to describe Germany's small and medium-sized companies. On the MDAX, for example, the average ratio of share prices to corporate profits is at an all-time high. It would take almost 27 years for the companies to earn what investors are paying for their stock. And even though analysts are predicting declining profits, share prices continue to rise.

Still, market psychologist Joachim Goldberg does not see a bubble forming in the German stock market. He too believes that a rise in the market only becomes dangerous when large numbers of people get caught up in the hype.

But there can be no question of that today. "This is perhaps the most-hated bull market I've ever experienced," says Goldberg, who used to work for Deutsche Bank and now runs his own firm in Frankfurt, where he studies what influences investors in making their decisions.

People noted that prices were rising, but at the same time they heard economists warning against the risks, says Goldberg, including the euro crisis, the interest rate turnaround or whatever the admonishers felt was the greatest threat at a given moment. For that reason, he explains, many private investors tend to be skeptical.

Plenty of Potential Problem Spots

But even Goldberg is concerned. "People prefer to invest in things with which they haven't had any negative experiences, such as the real estate market in Germany," he says.

Germans are also avidly investing in Bitcoin, the virtual currency that rose above $1,000 for the first time last week. In early October, one Bitcoin was still worth less than €200. The volume of the currency is limited by a complex algorithm, which also drives up the price.

"The same prophets who were advocating investing in gold until recently are now pushing the Bitcoin," says Goldberg. The behavioral scientist almost succumbed to the temptation himself recently. "I wanted to invest, but I hesitated for a day, and the price almost doubled the next day," Goldberg says with a chuckle.

The irritation he felt afterwards is what typically leads to speculative bubbles, says Goldberg. "When people see how their neighbors are getting rich with apparently no effort at all, and the psychological strain resulting from lost profits becomes too great, they begin ignoring the risks and jump on the bandwagon."

Will the next conflagration erupt online, with the collapse of an artificial currency that most people still see as a gimmick dreamed up by a few Internet nerds? Or perhaps in the art market, which has attracted speculators who fancy themselves art aficionados?

These niche markets are probably still too small to set off a global quake. Still, there are plenty of potential trouble spots.

Hedge fund manager Spitznagel, at any rate, is convinced that the next crash isn't far off. "We don't know where it is going to start," he says, "It won't be pretty."

Translated from the German by Christopher Sultan