Protecting Your Assets in the "Mother of All Bubbles"

In a commentary for the Financial Times, Nouriel Roubini of New York University recently warned that "the mother of all ... global asset bubbles" may be under way, in which all risky assets (stocks, high-yield bonds, oil, commodities, etc.) almost everywhere have run beyond what the fundamentals will bear. Roubini was early (and lonely) in spotting the housing / credit bubble. What's behind this new bubble, and how should investors respond?

Getting carried away
According to Roubini, investors are stoking a forest fire with the "carry trade" as their kindling. This is how it works: Investors borrow at a low interest rate in one currency and invest in higher-yielding assets in a different currency. If the exchange rate doesn't move against you, you pocket (at minimum) the difference between the yield on the assets and your borrowing cost.

Today, Roubini asserts, the U.S. dollar has become the borrowing currency of choice for the carry trade because the slide in the dollar compounds the Fed's zero interest rate policy such that traders are effectively funding the carry trade at negative interest rates. A negative borrowing cost certainly lowers your hurdle rate -- is it any wonder that all risk assets look attractive in that context?

A clue from Soros
The odor of the carry trade hasn't escaped George Soros: At The Economist's Buttonwood conference last month, Soros -- who has been known to speculate on currencies -- noted that the short dollar trade is "extremely crowded." A dollar-funded carry trade creates a short dollar position: First, you borrow in dollars; then, in order to buy assets that are denominated in another currency, you must sell your dollars against the other currency, i.e., you end up short dollars.

Saddled with pocketfuls of cheap dollars, investors have gone on a shopping spree, scouring the globe for any asset they expect to secrete a return above their borrowing cost. For proof, UBS says its Global Equity Strategy Risk index, which measures risk appetite, reached its highest level since March 2000 on October 23rd. UBS's comprehensive index looks at investors' preferences for higher-risk sectors and geographical regions, along with equity option volatility and conditions in the bond and currency markets. Historically, it has proven to be an effective signal to move into lower-risk assets, even below current levels.

A frenzied shopping spree
The results of this shopping spree are immediately visible in the relative performance of emerging markets versus the U.S. While the S&P 500 has delivered a workmanlike effort since hitting its closing low on March 9, rising 54.1%, that pales in comparison to more exotic investment locales. The average return for the 22 emerging markets tracked by MSCI over the same period is 90% in U.S. dollar terms. A third of these markets have more than doubled, including three of the four BRICs (Brazil, Russia, India & China):

Within the BRICs, some individual stocks have performed extraordinarily well:

Look at the returns on PetroChina (NYSE:PTR) -- these aren't penny shares; it's a company with a market value in excess of $150 billion! But the BRICs aren't the only frothy markets. In fact, value-driven strategist Andrew Smithers told Bloomberg in late October: "It's quite likely that Japan is the only significant market in the world that is not seriously overvalued." Given his expertise in stock market valuation and his superb track record as a "bubble-spotter," that's a worrying assessment for investors everywhere.

2 actions to protect your assets
The perspective of this "mother of all bubbles" bursting is unsettling, but there are a couple of actions that investors should consider in order to protect themselves against a possible correction, particularly investors who are broadly invested in the U.S. and major foreign markets (via index funds, for example). First, you can reduce your equity exposure in order to accumulate some "dry powder" that you can then reallocate in the event of a correction. Second, you can tilt your exposure away from the broad market and toward specific names or sectors. When implementing the second of these strategies, investors must be focused on selecting high-quality names that are trading at a discount to intrinsic value.

China is experiencing an asset bubble also, but there's more to China than the red-hot coastal regions. Motley Fool Global Gains co-advisor Tim Hanson puts his finger on the next great place to invest.