BULLS & BEARS: Fed policies encourage post-bubble hangovers

Economists teach us that too much money chasing too few goods causes inflation. As consumers, this supply-demand imbalance leads to rising prices on the everyday items we purchase.

A similar phenomenon can occur in financial assets. Too much money chasing stocks, bonds and real estate can create financial asset inflation.

Pension funds, institutions and wellheeled individuals are throwing money into “alternative investments” in the hopes of earning high returns. There are now an estimated 8,000 hedge funds that manage more than $1 trillion. Several private equity funds are raising mega-funds of more than $10 billion to make leveraged acquisitions of public companies.

These huge pools of money are raised under a guise that they can exploit market anomalies or redeploy poorly managed company assets and earn excess returns for their investors.

Yet, ironically, the popularity of these alternative investments with investors and their fund-raising prowess are contributing to a decline in their investment performance. With so much money piling into these funds, market inefficiencies are disappearing as prices on financial assets have risen. As a result, investment returns have compressed.

For example, arbitrage strategies in mergers and convertible bonds have seen returns shrink to money-market-like return levels. Also, the average hedge fund has underperformed a stock market index fund over the past two years.

Individuals, too, have gravitated to financial assets, namely real estate. Home prices in certain areas of the country have soared in recent years. In the hot real estate markets, buyers at current prices are sure to be disappointed in the future return on their investment.

Perhaps of greater concern is that this quest for excess return by both institutions and individual investors is being facilitated with cheap borrowed money. Wall Street investment firms lend copious amounts of money to hedge funds, and private equity funds are issuing junk debt to magnify their buying power. Individuals are able to obtain cheap financing from lending institutions to finance speculative real estate transactions. The lenders are eager to commit this capital for they earn substantial fees in the process.

Much of this easy access to capital can be traced to the actions of the Federal Reserve in response to the market bubble’s burst. An excellent front-page article in the June 9 Wall Street Journal discussed the apparent success the Fed has orchestrated in softening the economic effects of the bubble.

By dramatically lowering interest rates to encourage consumer and business spending, our economy avoided a more devastating deflationary spiral. The article, however, points to the dilemma now confronting the Fed in its quest to raise interest rates. The Fed is walking a tightrope in trying to remove some of the excess leverage in the markets that are propping up financial assets. If interest rates rise too high, there is the risk of a systemic decline in the price of financial assets.

Rational people can argue whether there is a housing bubble or why long-term interest rates are declining and bond prices are rising or why stocks deserve price-toearnings ratios near 20. But it is difficult to make the case that any of these financial assets, in aggregate, can provide the high returns many investors are expecting.