Zero Beta

A Note on Biases

Lately I have been thinking a lot of Media and biases.  Therefore, before I post again, I want to digress a moment on biases.  I think the biggest problem in our Media is the lack in disclosure of biases.  This causes a dangerous polarization of our citizens into two extreme groups: 1) the cynics who see the bias but resent that someone is blowing smoke in their face – further fueling their cynicism. 2) blanket believers who don't look for biases and are in turn "brainwashed" by those who wish not to disclose them.  I believe the biggest idea or development that has emerged from the advent of Google is the classification of information as an Asset.  Media is simply information and its higher orders – knowledge and wisdom.  As information begins to be recognized as an asset, Media Professionals and their Outlets become less like Reporters and more like Portfolio Managers – with the "fiduciary" responsibility of managing their "clients" (or readers/subscribers/viewers/listeners) informational assets.  Financial Professionals should know that any conflict of interest should be disclosed when acting as a fiduciary, therefore any media outlet should disclose biases beforehand so that "investors" are neither tricked nor disenfranchised – enabling a "market" for information to exist. 

As a realist, I know that it is impossible to eliminate biases from Media – especially blogs.  I believe bias is very dangerous in New Media (financial or otherwise) because it always exists and can be assigned an intangible but real dollar value.  The idea of personalization of one's informational sources inherent to New Media allows biases to thrive and grow.  A blog or website that vows to go against Media Bias introduces a new one.  This doesn't help matters but only makes them worse. Even the blogger who is simply posting news stories transmits an inherent survivorship bias in what stories get chosen (See Drudge Report and Huffington Post).  Bloggers have the advantage of simultaneously being their own editor and self employed (in most cases), therefore they have a much greater opportunity to break down the wall of biases than "old" media journalists.   I have already disclosed that I am a 24 year old – which I hope does not take anything away from my ideas because I believe they are much more sophisticated than some people twice or even thrice my age, and a voice for my generation is a relatively scarce asset.   Instead I disclose my age to reveal the biases that come with that number and are unavoidable – naivety, lack of experience, and a tendency towards idealism. 

That being said I plan on disclosing any biases I believe I may have before my posts in hopes of more widespread acceptance of this idea.  Although it may take something away from the "journalistic experience" – I believe the rampant existence of biases along with the widespread ability to choose one's source for information threatens Media and Society as we know it.  Although the disclaimer on a pack of cigarettes may take something away from the smoker who has to glance at it every time he/she lights up – society as a whole is much healthier and now thinks about what they inhale.  I hope that my choice to disclose biases up front in a blatant manor will be accepted more widely and have similar effects.

That being said, I will list what I believe to be my informational biases and COI's below. In addition before any future post I will include a reference to this post and any other biases that I feel are specific to that discussion – in hopes that other "Informational Asset Managers" (aka bloggers, reporters, newspapers, television stations, magazines, data sources, publishers, etc.) follow suit.  If you ever read this blog I encourage you to read all of these things.  It may seem like an arbitrary list and some items may appear to be unimportant or superfluous but I assure you that I took great care in the scrutiny of myself in order to make certain that any bias that may come through in my work is fully disclosed.

 

Biases inherent to my posts

1. I am a 24 year old male with less than 3 years in finance.  I have primarily witnessed a historic bull market and grew up in the time of MTV, the internet, hip-hop, Wal-mart, and "bling".   
2. At the core, I am very bearish on the Economy right now and on the future of this country as a whole.  I believe that demographics was the cause of our prosperity but people in general don't want to believe that something so great but at the same time uncontrollable explains this phenomenon.  Instead the existential desire to find meaning causes misplaced ideas and money.   
3. I work in Private Wealth Management managing client's assets. I do not believe my blog is a conflict of interest as I am not widely read enough nor is there a disparity from what I write here and what I tell clients (for the most part).  Any ideas that I have are not a recommendation for investment but rather an idea that I have on the economy and markets.  I understand the implications of this fact but I dislike the fact that the financial industry is legislated based on what a few "bad eggs" have done.  In the end of the day it hurts the investor as he or she can no longer be told what is or isn't true.  Instead disclaimers, broad language, and lack of ability to convey ideas skew and distort the important facts that they must receive.
4.   I believe in conservative asset allocation and focus on managing risk over return.  I believe that passive management should be coupled with active management and believe the most important decision an investor could make is their percentage allocation of equity to fixed income – the rest creates limited alpha for your client and does more to satisfy their "emotional" financial needs – which still are important.  A client who is happy that you put him in an interesting or new investment for part of his/her equity allocation (and has something to talk about with his/her friends) is much less likely to question his/her actual allocation to equity – which is much more important and will do them better over time.  Although for most individuals an indexed portfolio is the best and most cost efficient way to ensure they meet their financial goals – money is a very emotional object and active allocation is at times necessary to prevent boredom and the subsequent bad decisions that it causes the common investor to make.  I believe someone is much more likely to move the majority of their money from a conservative indexed portfolio to a speculative fund or company if they don't have a new idea or something to talk about on the golf course or the cocktail party.  I would much rather choose that "risk' than have them blindly throw money in an emotional "trade" taking the chance that they do not realize their intended return to the mean. 
5. I went to the University of North Carolina at Chapel Hill and majored in Economics and minored in Mathematical Decision Sciences.  I did not go through the Undergraduate Business program because I was not accepted.  I take it as a blessing as I have since come to believe that undergraduate Business Programs are nothing less than cookie-cutter Vocational School where nothing important is actually learned.  It is causing homogeneity of beliefs and ideas in the business community and the ignorance of sciences and humanities such as Mathematics, Psychology, Economics, History, and Philosophy.  You may interpret this as spite but I urge you not to employ that skepticism in this instance. I disclose this information as I am very skeptical of the education received by my generation – and this is where the skepticism derives from.
6. I come from a middle class family and a middle class town 50 miles north of NY.  I went to a public school and graduated from a class of about 500.  I played sports, enjoyed an active social life, and did well academically.  I hung out with the "popular" kids on the weekends and had classes with many of the "nerds" (I use this term with a hint of sarcasm).  I disclose this only because I believe it lends light on some of my views on my generation and society – not to brag or to show that I was some sort of jack-of-all trades. 
7. I come from a very liberal background.  My parents are both educators and staunch Democrats.  I am very middle of the road in my political beliefs.  I would consider myself a Libertarian and believe in free markets and small government.  I am very dissatisfied with our current political situation which includes the Bush Administration and the majority of the Republican and Democratic parties.   I believe that our political system is broken and our leaders are corrupt, incompetent, and puppets to their corporate and wealth donors on hand and their extremist voting bases on the other hand.  Please do not take any criticism of Bush or the Administration as a liberal bias but as this type of political bias.  Remember correlation does not mean causation.
8. I grew up without a religion.  My mother was Jewish and my father Catholic.  I did not go to church and quite frankly do not like organized religion at all.  I could care less what people believe in as long as I am not forced politically, socially, or otherwise to go along with them.  I would not want to force anyone to live my empty life devoid of Faith and God and in turn do not want to be forced to live someone else's life filled with what I see as Blind Faith and Ignorance.  I do not mean to offend anyone by this admission but rather to allow them to understand my ideas more clearly and without obscuring fact for belief.
9. Beginning college in 2001, I was forced with the problem of what I thought to be my college savings gone.  I do not blame my parents for this as I know that it happens.  Instead I have set out to educate those who may make the same mistake and encourage wise financial planning.  You can say this has left me very biased towards avoiding bubbles – admittedly probably too biased.
10. That lack of college savings along with some past foolish financial decisions has left me with more debt than I would like to have at this age.  Although I have a good job that pays well – the amount of debt I have sickens me and this bias will be evident in any posts on credit.  Take this however you wish.  I know my mistakes are not universal but also understand debt more than people who have none.
11. I have a tendency to believe that I am smarter than other people and have everything and everyone figured out. It is a curse of intelligence and an awful way to live.  I know that this is something I can not change and rather than live in a state of denial, I confront the fault.  Sometimes I am correct, most times I am not.  Instead of coming off pretentious and condescending I choose to disclose this instead of having it bleed through my ideas and be criticized for it.  I believe that most people of high intelligence have this problem in one form or another, but without recognizing it and working around it they are never fully able to realize their full potential. 
12. I believe markets are largely inefficient but that our lack of understanding of what efficiency is limits our ability to capitalize.  The lucky who take a stab and succeed in turn believe that their success is indicative of their understanding.  Without understanding what efficiency is or equilibria exist any attempt to capitalize on them is a random crapshoot where the winners are deemed experts.  It both as abstract and, in turn, useless a term as heaven, hell, love, hate, freedom, or hope.  I believe efficiency is defined post-facto by those who believe they uncovered it's opposite "inefficiency" and defining something by something it is not proves utterly useless.  Markets are always inefficient. 
13. I believe that little real value can be obtained through P/E ratios, ROE, Gordon Growth Models, and other financial measures on their own.  The only value is in the market's perceived reaction to some value but a stock is not "cheap" because it is trading at 7x earnings, it is cheap because you believe there will be increased demand and a higher price for that asset later – period.  Whether the P/E ratio justifies this is up for debate.  I would argue that looking at its business, future market conditions, economic outlook, and growth opportunities are much more important.  Since these ideas are difficult to quantify we rely on such numbers as a crutch.  Since we have no idea what will happen in the future, I would much rather invest in something that is logical than lean on estimated numbers in an imperfect formula or model to reaffirm my beliefs and add to my bias. 
14. I chose to write this blog primarily as an outlet for my thoughts and my desire to convey ideas to others.  I would be remiss if I failed to also recognize my opportunistic and egotistic to be noticed.  I am a young adult beginning a career in Finance.  I believe that I know much more and have greater ambition and love of Finance than many of my colleagues who have better jobs that I would kill for.  Since I chose not to go the B-school route and graduated with a less than stellar GPA I have been forced to work my way up.  Since I don't have the pedigree that is necessary for what I really want to be doing, I believe I must have something that shows not only my mind but my dedication, sophistication, and general interest in this subject.  Although this is primarily academic in nature to fail to disclose my opportunistic intentions would be negligent and wrong.

-β

Consumer Credit Report Is In - More of the same

Today the Fed released its latest Consumer Credit Report.  A few items...

• On a seasonally adjusted basis, Revolving Credit increased at a 9.2% annual rate.  Non-revolving increased 5.2%.  Total consumer credit increased 6.7%. 

• Without seasonal adjustments most types of credit remained relatively flat.

This leads to a few interesting conclusions.  First, in March Consumer Credit historically decreases.  I'm assuming that this is because tax returns start rolling in and consumer spending slows slightly.  So in a month that it was supposed to decrease by about 9.2% annually - it remained flat - showing that those who paid off either did not pay off or were off set by the people who took on more - Not a good sign for the American Consumer who I mentioned earlier is addicted to debt.  It is however a good sign for corporate earnings who rely on this addiction. 

-β

Hi, My Name is America and I am Addicted to Debt…

Mastercard's EPS:                 $1.57

 

First Call Estimate:                $1.14

 

Market Reaction:                $129.10 + 14.25

 

America's 25 Year Debt Bender:        Priceless

 

Wednesday, Mastercard was the talk to the street as it blew away earnings estimates with a 70% increase in profits. The market stopped to applaud as it continued its drunken ascent. I believe that Mastercard bulls are justified in their bullishness. However, I don't think Mastercard's success can coexist with the rest of the market in the current lending environment we face. As buried in that earnings report are signs of a global Debt-addiction quickly spiraling out of control.

Whether you believe in the materiality of sub-prime lending's effects on the Economy or not, consumer lending has and will continue to tighten up. Congress is going to investigate the practice and most people will not want to be even associated with a sub-prime loan. Well, nobody except the credit card companies (more on that later). Although Mastercard benefitted greatly from global growth (as many of our companies have), its U.S. purchasing volume still increased nearly 8%. After hearing the earnings call on Bloomberg, I was struck by a comment by one of the commentators when she said, "This confuses me. Where is this borrowing coming from?" Mastercard and its Homeboys – The Plastic Pushers. Let's look at the figures. I have graphed data obtained from the latest consumer credit report of Revolving Debt and Real Estate Debt Outstanding:

Source: Consumer Credit Report Data

It was quite difficult to find good data to state my case so bear with me (It's funny how the data that portrays reality is either discontinued or updated infrequently – probably just a coincidence). The actual credit card data was not adjusted for seasonality, and rather than tinker with data I put this up. If anyone has any better or more accurate data they would like to post either supports or refutes my case be my guest. I'm not that big on Economic Data anyways ever since meeting with someone who once put it together. He said they basically would "make up" data in order to hit a deadline – similar to my actions to dealing with Physics labs in High School. Moving on - although Revolving Debt includes loans other than credit card debt – credit card debt is revolving. I know this is poor logic but revolving loans are usually unsecuritized, therefore should command a higher rate. We can see this relationship pretty much throughout the data – with lower cost readily available debt for the most part takes up most increases in debt use. Clearly, real estate debt took a nose dive in the first quarter, but revolving debt didn't come along for the ride. This is because the American Consumer is addicted to debt and its effect – Consumption. With the Government cracking down on sup-prime mortgage loans (called "Brick" on the streets) and their dealers feeling the heat – what is a Consumer left to do but try to go score some unsecured debt, aka "Liquid Plastic". Since the consumer has inflated the value of his/her securities (i.e. their house – not to mention the stock market and retirement assets), her or she must move on to the harder stuff – the Liquid Plastic. Sub-prime loans, or "Brick" can be thought of as the "Gateway Debt" and as we all learned in health class – if not used recreationally, this kind of debt is much more expensive, dangerous and will eventually screw your life up. Let's see how "Liquid Plastic" is a much more expensive Consumption fix than "Brick". Let the extended metaphor begin…

Below I have listed quarterly lending terms:

Source: Survey Terms of Business Lending

This chart is straightforward, Liquid Plastic is much more expensive than any secured debt – which closer to the New Car Loans (or "Speed"). Below I have listed an additional table which portrays how Brick can be so addictive.

Source: FreeLunch.com

 

This chart shows the Prime Rate plotted against the 30 Year Mortgage Rate. It basically shows the economics behind a Brick addiction, aka SUB-prime loans (see 2005 onward). This data was updated for the 1^st Quarter and from here on out the 30 year rate is worthless to most consumers. They are more likely to pay a rates of Prime or higher if they want some Brick, but they've already used too much of their home equity on that anyways. If you are an average consumer basically you can either finance your house or get a personal loan or credit card. Personal loans will be offered at or above Prime because they are unsecuritized and require a higher rate of return. Therefore, at this point people are and will continue borrow at a higher cost than they have in the past. Since consumption has remained strong and Real Wages have been somewhat stagnant, consumers are now starting to drain their personal equity at high costs to Consume.

This data illustrates how addicted the Consumer is to Brick and why Liquid Plastic is going to be dangerous. With a modest job recovery offset by inflation there has been stagnant wage growth. Falling home prices add on to this along with abysmal savings rates – yet Consumer Confidence remains high. How can this be so? Well, maybe the Consumer is "high" on Consumption.

The availability of Brick, Speed, and Plastic has severely altered has severely screwed up collective consumer and market psyche. Benjamin Franklin wrote, "The definition of mental Insanity is doing the same thing over and over and expecting different results." We did our fair share of Brick in the '80's and saw some of the effects, after a few years of trying to stay clean – we experimented with Liquid Plastic in the 1990's as well as Corporate Brick and saw the effects again. A tragedy struck us in 2001, however and it really hit home. Unable to deal with our emotions we decided to drown ourselves in debt – chasing another Consumption Buzz and soon enough got heavy into Brick, Speed, and now appear to be moving to Liquid Plastic. Let's examine how this progression has occurred in more detail. (From here on out I will use the collective "we" to describe Debt-addicts – because we all are).

A major side effect to debt-abuse is inflation. Our experiments with Brick in the 1980's caused housing inflation, in the 1990's liquid plastic and Corporate Brick helped add to stock market inflation. Well, surprise surprise…it turns out that Over-Consumption can lead to inflation. We not see this, instead we lump the two together because of the positive response mechanism it brings. As we see our assets inflating with their use of Debt we believe this is good – and at first it is. However when food and energy prices start to go up because of using Speed to Consume Hummers and Tahoe's, we need more debt to get the same buzz. After Brick helps us get that buzz back from buying a McMansion or a beach house – they soon find ourselves unable to get the buzz from that either. We believe we need more debt to get out and fellow Brick-heads shout on CNBC yelling at the Fed to relax some of the regulations so that we can get more cheap Brick. The Fed, in attempts to curb an epidemic stands ground – at least it seems. While appearing to fight a war on Debt behind the scenes, a covert operation is going on in the background to try to make Brick, Speed, and Liquid Plastic more readily available on the streets - using the tax revenues the added Consumption brings to fund some of its less than popular missions (much like the CIA has rumored to have done in the past and continues to do with heroin, cocaine, and other common street drugs). Debt addicts start to become unstable and desperate as they hear that their Brick supplies are drying up and begin to go on a binge of consumption and inflation hardly awakening from its Debt-induced stupor. At this point Brick, Speed, and Liquid Plastic have spread overseas and are beginning to develop the same collective psyche's – altering correlations and relationships that were once the norm, as Barry Ritholtz points out. Enter Mastercard.

When I think of credit card companies, 70% EPS growth isn't really something to expect unless you have a world of Debt-addicts – which is what he have. Mastercard knows this and like other companies who produce addictive products (Phillip Morris, Wynn, MGM, Merck), they have a strong lobby and have already insured that they can reel in as many Addicts as possible with the Consumer Credit Card Protection Act of 2005. Similar to a bartender or casino who reels addicts in with freebies or "first one's on the house" type deals, this act allows companies to offer teaser rates and other perks and makes it much harder for them to leave eliminating Universal Default – even when they have had too much.

So yes, Mastercard's earnings were good. I have no reason to believe they won't continue to improve. With a nation, moreover, a world filled with "debt-heads" and by securing themselves as the lender of last resort, they have probably booked those gains for another year. But, debt-heads will soon learn that their consumption of Consumption through Debt is killing them. The other thousands of companies and their shareholders will feel the sting as well – as they are also debt-heads and consume through the income they generate from other debt-head's Consumption. In Economics it is called the Multiplier and is directly related to the Marginal Propensity to Consume. Hopefully, the future won't be so bleak, but Mastercard's latest quarter and the tape would say otherwise.

-β

Technology Bubble (1996-2000) vs. Financial Bubble (2003 - ?) (Part II)

Part II of the post...

 

Bubble Indicators

 

Internet Bubble	Financial Bubble
Outrageous IPO deals	Outrageous Private Equity Deals
People starting Dot-Coms in their garage	People starting Hedge Funds in their garage
Mary Meeker, Jim Cramer, et al.	Mary Meeker, Jim Cramer, et al.
Silicon Valley the hotbed of Young Techies	New York City the hotbed of Young Financial Pro's
Day Trading	Day Trading
Mutual Fund ads on CNBC	Mutual Fund ads on CNBC
HBS grads go to "dot-com's	HBS grads go to PE & Hedge Funds
Corporate Chicanery	Buybacks, Options backdating
Companies overleveraged	Consumers overleveraged

 

Scandals

The major scandals to come out of the Tech Bubble and that time period were Worldcom, Enron, and the "Chinese Wall" scandals involving the investment banks and their research analysts.  Since both Worldcom and Enron have been discussed to death, I will touch briefly on the "Chinese Wall".  Back in the 1990's (and probably still today), Investment Banks would pressure their research analysts to write up good research on a company in order to win banking business.  This artificially pumped up stocks to the benefits of the executives and the bank and to the chagrin of the shareholders. 

Although no major scandals have come out yet.  I believe they will come from this area:

1. Options Backdating – the only reason why it wouldn't is that everyone was involved and the SEC isn't going to take down the entire economy.
2. Private Equity – it is my suspicion (somewhat unwarranted), that there is something sinister behind the companies that they scoop up.  Historically, PE has had government/political ties and that means are subject to the influences of politics and power.  The recent purchase of Sallie Mae amid government investigations and a looming credit crunch struck me the wrong way.  By taking companies private that may have violated the law or engaged in shady dealings – they have erased the possible Enron's, and Worldcom's of this market.  It also takes away the deterrent of wrongdoing. 
3. A major lender will have a major scandal – As pressure mounts with indebted baby-boomers approaching retirement, Credit card companies and lending institutions will come under much greater scrutiny.  Although I may not believe in the prosecution, if you have an angry voter-base you are very likely to throw someone to the wolves and I think these companies have enough dirt that will stick.  Although their lobbies are strong, power is stronger. 
4. Federal Bailout of a Hedge Fund – it's going to happen again – just a matter of when. 
5. Class Action Pension lawsuit against Major Banks and Hedge Funds.  Show me a major blow up and I will show you a major court case. 

 

 

Important Major Difference

The important major difference is that in the Financial Bubble, the very industry that has created and maintains the bubble is the gatekeeper.  The industry has great power – with many former Wall-Streeters in high government positions.  The wealthy and powerful have money tied up in the bubble and therefore much more willing not to see all hell break loose.  This should not be underestimated.  Wall Street – at its foundation – was largely shielded from the effects of the Tech Collapse.  It will not be the same this time.  With the U.S. losing its grip as the center of Global Finance, the stakes are high will be defended aggressively.   I hope the globalization advocates are correct but for some reason this scenario seems all too familiar. 

Technology Bubble (1996-2000) vs. Financial Bubble (2003-?) (Part I)

Many bloggers, journalists, and authors have equated the current Financial Liquidity bubble with the Technology bubble of the late 1990's.  The Tech bubble was defined by the internet or "dot-com" stocks that rose and fell during the late 1990's and early 2000's.  The Financial Bubble is defined more by the rise of financial derivatives and institutions but involves the entire economy and markets much more so than the Tech Bubble ever did.  Some will argue that our current situation it is not a bubble and that we are just spreading risk around the system more efficiently.  The people who understand risk know that risk has been spread around the system – dampening volatility.  These people will not, however, agree that this negates the possibility of a bubble.  Risk transfer is risk TRANSFER and nothing else.  It is NOT risk reduction.  For every hedge bought there is someone on the other side of the trade, and behind every "hedged" position there is a model filled with biases and probability distribution approximations.  The only risk worth hedging at this point is the one that everyone is wrong.  Without getting into global liquidity, derivatives, and all the other topics that have been beaten to death, let's review how this bubble relates to the Dot-Com mania.

 

Theory

Both the tech bubble and the financial bubble have been dominated by theorists and theories.  The tech bubble, at its roots, was grounded in the theory of Moore's Law – that the processing capability of chips would double every 18 months.  People took this to believe that the internet and its companies would grow at the same rate as well.  People believed that these companies were immune to systematic economic risks such as recession, and well – bubbles.  When this turned out not to be the case, people realized that they were foolish and shares sold off sharply and the bubble was popped. 

The financial bubble has been dominated by Globalization theory.  This is a hodgepodge of different economic, social, and political views.  Thomas Friedman (The Lexus and the Olive Tree, The World is Flat), a pioneer in the movement describes the basis:

"... not static, but a dynamic ongoing process: globalization involves the inexorable integration of markets, nation-states, and technologies to a degree never witnessed before--in a way that is enabling individuals, corporations, and nation-states to reach around the world farther, faster, deeper, and cheaper than ever before, and in a way that is also producing a powerful backlash from those brutalized or left behind by this new system. ...The driving idea behind globalization is free-market capitalism--the more you let market forces rule and the more you open your economy to free trade and competition, the more efficient and flourishing your economy will be. Globalization means the spread of free-market capitalism to virtually every country in the world. Globalization also has its own set of economic rules--rules that revolve around opening, deregulating and privatizing your economy"

-Thomas Friedman, The Lexus and the Olive Tree

Although I agree with many of the ideas behind Globalization, I do not believe that we have gotten it right.  The spreading of risk and the openness of government along with the idea of a positive sum game has led to a credit crisis and huge global imbalance. 

The Global Economy is an unchartered territory, with many surprises in store for those that think they have the map.  If you were to ask the owner of Pets.com at the height of the dot-com boom if he believed that they were in a "New Economy", ripe for returns, he would have unequivocally said "Yes."  The pundits that you see on TV are no different.   It will be interesting to see what the headlines for this bubble and its underlying "pioneers" will be when the time comes. 

 

(mis) Valuations

Back in the Dot-Com days, stock market valuation was defined by a few concepts.  First, was the aforementioned Moore's Law that the internet growth would double every 1.5 years.  This allowed for universal incredible growth rates and the false predictions that revenues equaled profits.  Speaking of revenues, the second characteristic of this market was that a "Dot-com" should be valued by sales.  Although the "burn rate" for these stocks was high at first, they were all assumed to eventually turn a profit and inhabit the great "Castle-in-the-sky".   This led to the philosophy of "get big fast" if a company could gain enough market share profits would come.  What was seen is that the revenues didn't turn into profits, market share was only captured by the few, and most companies were worthless.  The major mis-valuation was the idea that top line growth would move to the bottom line. 

The Financial Bubble's mis-valuations are much more subtle.  As mentioned earlier – this is not a bubble that has been contained within the sector (although the tech was not either).  This bubble is the idea that capital markets are much more efficient, interest rates can remain low, inflation inexistent fueling prosperity, consumption, and investment.   Just as the internet bubble involved the over-estimation of the growth of the internet, the financial bubble involves the over-estimation of future economic and earnings growth.  There are a slew of issues that lead to this rosy forecast.  I will touch on a few:

1. Basis on past data.  Relative valuations and earnings growth estimates are based on past history.  When an analyst on CNBC speaks that companies are historically undervalued at 17x earnings, he is using the data that INCLUDES the prior overvaluation.  This exerts an upward bias on expectations and has fueled pressure on Central Bankers to create an environment where it exists.  The belief that earnings are going to grow at 10% + continuously is naïve and short-sighted. 
2. Central Banks and the Financial System are much more efficient at managing risks in the global economy.  I will concede that they have gotten better at managing the risks that occurred in the past, but that says nothing of what may occur in the future.  They also have not been managing risks as much as delaying them.  Remember, the Fed bailed out LTC in 1998, and Greenspan bailed out the U.S. economy in 2002-2003 – slashing rates to nearly zero.  Many risks exist and are very real.  The Fed has little control over most of them except for  checkbook and a printing press (both of which may not work the next time)
3. Overstatement of Equity Risk Premium/Long Run average returns – The equity risk premium has been overstated for years.  The truth is if everyone belies that stocks are going to return on average 10% a year (it used to be 7%) as in Siegel's Stocks for the Long Run, then they in theory erode away much of that premium as they buy what they deem as a "risk free asset" – causing equity returns to fill in for Bond returns in the CAPM equation.  This is referred to as the "Equity Premium Puzzle."
4. Over-leverage of the American Consumer.  Our companies' earnings are directly related to how much our consumers consume.  Years of easy money with little wage growth has caused enormous debt loads that will begin to affect their consumption habits.  This causes earnings and revenue growth to both be overestimated – explaining the attractive valuations.
5. Ignoring the demographics – It is no coincidence that the largest demographic shift experienced their most productive years during our historic bull market.  Demographics can explain much of the growth that occurred, and will be attributable to much of the slowdown to come.  The next 10 + years will bring many problems as the government will be forced to deal with many of the social entitlements that their voting block expects.  This could dampen economic activity and earnings growth.   
6. Hedge Funds eliminate/soak up risk – Not too sure whether this is true or not.  All it would take was some correlations to emerge that never existed or some Black Swan event to prove this wrong.  Since we can't see what they are sitting on there is a risk inherent in that anyways. 

Although the Tech Bubble was characterized by much more glaring overvaluation, when compared on a future earnings basis – both are very overvalued.  Taking inflation into account – things haven't been rosy for some time.

 

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