President-elect Barack Obama is looking to fill his administration with longtime Washington hands. Above, Rahm Emanuel, the chief of staff.
His choice for secretary of Health and Human Services, officials said, is former Senate Majority Leader Tom Daschle, who has a long Washington résumé. Jacob Lew, one of President Bill Clinton’s budget directors, is favored to direct the National Economic Council
http://www.lawyerschicagoblog.com

Bubbles are periods when wealth grows dramatically, even spectacularly, fast.

However, it is not true wealth that is created; it is only the illusion of wealth.

True wealth is produced by the concentrated efforts of human beings, generally over extended periods of time, applying their unique skills and talents to challenging endeavors. Wealth is the result of value being added to our economic system; of needs being satisfied, of dreams being realized, of engines of growth being nurtured and brought to fruition. Examples include the creation of a viable business; the construction of a home; the education of a nation; the building of bridges and roads.

Bubbles, on the other hand, involve speculative activity, and create wealth through no apparent effort. That is their great deceit, and what makes them so alluring. In a housing bubble, one month your house is worth $500,000; the next month, it is worth $550,000, even though you have made no improvements to it. In a stock market bubble one day IBM stock is worth $80; a week later it is worth $100, even though the company and its earnings are the same.

Bubbles are the fulfillment of false dreams, the pot of gold at the end of the rainbow, the Seven Cities of Gold, the winning lottery ticket. Bubbles are wealth without pain, without sacrifice, without effort. As such, they corrupt the spirit as well as the economy.

Easy wealth leads to an entitlement mentality. It convinces individuals that wealth is a birthright; they merely have to wait for it to appear. Bubbles destroy individual initiative and the work ethic. They encourage meaningless activity, the spinning of wheels in the mud. The roar of the engine may give the impression of going somewhere, but the car really isn’t moving.

Is it any surprise, then, that when bubbles burst, as they all must, that the consequences are devastating? The effects are felt not only on the economy, but on the spirit of the people as well. The mirage of effortless wealth is shattered. Markets collapse. Assets depreciate rapidly. Homes and jobs are lost. Retirement is postponed. Lifestyles are downgraded. Dreams are deferred, if not lost forever. Ask anyone who lived through the Great Depression! It is all very sad, and all very unnecessary.

Bubbles should be pricked before they become dangerously bloated. Although we live in a capitalist system of which “free markets” are a vital part, it does not mean that markets should operate without constraints. We also live in a “free society”, in which individual rights are respected and protected, but we do not allow the actions of single individuals to endanger the system as a whole. Should we allow the actions of individual companies, or industries, threaten the entire global economy?

We have endured three major bubbles in the last ten years: the tech industry bubble, a credit bubble, and a housing bubble. Someone, somewhere, should have recognized the formation of these bubbles early on, and taken measures to deflate them. Perhaps it should have been the Chairman of the Federal Reserve, or the Chairman of the SEC. Perhaps it should have been Congress, or the President, or the banks and mortgage lending firms. All could have had an effect. But none did anything till it was too late.

As a result, we are forced to live with the consequences of three major bubbles bursting, virtually simultaneously. The effects will be severe and long-lived. People always underestimate the impacts of a bubble bursting. If you recall, late in the summer of 2007, when the mortgage-backed securities crisis was first being recognized, estimates of losses were only about $150 billion, and the hopes were that banks could write that all off in one quarter, then get on with business as usual. Now, estimates of the write-offs have grown by ten times! It will take years for financial institutions to purge themselves of this “toxic waste”, even with the help of massive government programs. Many will not survive.

It is fair to say that at no time in history have three bubbles burst in such a short time. That is why the behavior of markets today is so erratic and volatile.

The effects of these bubbles are global, unprecedented, and totally unknown. It is difficult to determine the value of financial assets, such as stocks and bonds, when circumstances are changing so rapidly. I am unable to assess the degree of risk in financial investments today. If one can’t assess risk, one can’t manage it.

In highly uncertain times, people rely on past experience, on rules of thumb, on their intuition. But all of these are likely to be misleading today, because the “rules of the game” have changed. It has been said the one never forgets how to ride a bicycle. However, if a third wheel was added to your bicycle, and the wheel was placed at right angles to the other two wheels, you might encounter difficulty in controlling it. You might find yourself driving in circles and not understanding why!

It is no surprise, then, that so many financial experts on TV and radio confidently give advice which seems to fall flat. Counsel which would have been sound in fairly normal times seems to blow up in their faces. You’ve heard it before: “Don’t try to time the market”, “A bottom is near”, “Stay the course, things will get better soon”, “Buy defensive stocks, they will hold up better”. This sounds much like advice which was given investors in 1929 and 1930. It proved to be less than optimal, to say the least.

Despite all this encouraging advice, the stock market continues to decline; all stocks, even those of great companies, seem to get “killed”, and the coveted market bottom remains elusive. This is typical of post-bubble bear markets, which follow bubbles as surely as night follows day. Bear markets purge the economic system of the excesses of the preceding speculative mania, which characterize bubbles. When will the market bottom? Generally, when there are signs that the end of the purging process is nigh. We have quite a way to go to reach that frontier. It could be sometime in 2009, but it may be later.

We know from Part 1 that markets are prone to “overshoot” what many would consider “fair value”, often by a large amount. That is because bear markets are driven by fear, while bubbles are propelled by greed. Two opposite sides of the same coin, they each promote human behavior which results in extremes in market action, to the downside or upside.

Symptoms of overshoot are appearing in this market, roiled as it is. Should General Electric Stock be selling for $17 a share and sporting a 7% dividend yield? Should Freeport-McMoran stock plunge from 117 to 25 in just 6 months, and sell at a P/E of 3? Probably not- these may prove to be phenomenal long- term values. Yet, in the type of secular bear market in which we are immersed, GE stock may yet see $12 per share, and Freeport-McMoran may visit $15. These are not predictions- just analogies to earlier bear markets.

Make no mistake about it, there will be a recovery, even if it seems remote. It must be understood that above all, markets are cyclical, although these cycles can be highly irregular. After excesses have been purged from the system, markets begin the process of recovery. At first, that may be slow and halting, particularly when severe damage has been done to the financial system, as I believe has occurred in the current instance. But, unless you believe in the complete collapse of human civilization and the ascent of the cockroach (which I do not- I hate the little buggers), advent of recovery is just a matter of time. How much time is problematical.

Do you dread that last hour of the market day, wondering whether the market will skyrocket or nosedive-either way prompting another flood of client calls? Do you wake up worrying in the middle of the night about your clients, your business, your own investments, your family? Do you ruminate on the Keynesian observation that “the markets can stay irrational longer than you can stay solvent?”

You’re certainly not alone. We’re looking at what may be our worst bear market since the 1930s, with worldwide government interventions on a scale never before seen and a longer-than-usual recovery. Trillions of dollars of assets have vanished and no one is immune from worry.

We’re also living in a time when the media is such that we hear bad news the instant it emerges . . . repeated and repeated and repeated. We hear it on the radio, see it on TV, read about it in the morning papers or throughout the day on any of a dozen websites and blogs. There’s no escaping the talking heads’ minute by minute descriptions of what we should worry about and what we should believe.

On the other hand, as professionals we know the market is ultimately driven by fundamentals; that hasn’t changed. We know the markets will recover; that hasn’t changed either.