Inflating the echo bubble

(breakingviews.com) -- Is irrational exuberance back in markets? Evidence and examples abound suggesting that it might be.

With market chaos abating, the return of risk appetite in stock and lending markets is logical -- up to a point. But risk-taking that aspires to the boom-time norm, rather than a more sober new reality, could be premature and dangerous.

Of course, it's important not to get stuck in a crisis mentality. Markets probably overshot to the downside, and some level of recovery is therefore only a return to a sensible middle ground.

For instance, the risk premiums over U.S. Treasury yields on junk bonds, now roughly 8 percentage points, are more or less back to where they were before Lehman Brothers went bust a year ago. They are still much larger than their 2007 bull market levels below 3% and well above the long term average, which lies somewhere in between.

The Chicago Board Options Exchange VIX index of U.S. stock market volatility -- also seen as a gauge of investor fear -- is in the same category. It spiked massively after the Lehman collapse and has subsided, but is nowhere near its lows.

So far, so good. But there are clear signs of an overshoot on the upside -- an echo bubble, along the lines already seen in Chinese stocks (whose ups and downs appear to have led those in the rest of the world for the past couple of years).

Sensible analysis of stock prices, for instance, suggests that after the run-up of recent months, little in the way of crisis aftershocks is priced in, and some see markets as overvalued. Yet as one Citigroup strategist put it this week, "There's an expectation of better-than-expected results".

A recent rash of bond issues and mooted stock offerings can be seen as a return to business as usual. But some also look overly opportunistic. When Blockbuster, until recently widely seen as an anachronistic video rental business condemned to permanent decline by the digital revolution, can pull enough demand to double a debt offering to $675 million as it did Wednesday, it begs the question whether investors are looking for an early return of bull market conditions.

Similarly, Kodak -- another company struggling with a secular decline of its core business -- was able to raise $700 million from a sale of securities to investors led by buyout house Kohlberg Kravis Roberts.

Even AMR, the parent of American Airlines, sold air miles and tweaked its aircraft financing to gain access to nearly $3 billion of extra funds, a move that sent its share price soaring more than 20% at one stage on Thursday.

There is also anecdotal evidence that banks are once again willing to fund leveraged buyouts, and that the terms under consideration have become rapidly more aggressive in recent weeks -- almost as if the participants are stretching for the heady debt ratios of a couple of years ago.

The ramping up of prices for commodities like oil and gold also suggests a return of speculative activity, although gold -- for example -- may also be in favor as a hedge against possible inflation.

Either way, though, it's hard to escape the feeling that all the cheap government money still sloshing around and keeping short-term interest rates down is more likely than not to stoke a new bubble now that animal spirits are revived.

Investors are also "tired of talking about the macro issues", again according to the Citi strategist. That's understandable and perhaps no bad thing given the return of a modicum of stability to markets. It makes sense, for instance, to distinguish between the investment potential of different companies rather than indiscriminately tarring all their stocks and bonds with the same brush.

Yet the things that keep people awake at night are still the big macro concerns. Is the U.S. consumer going to pull back further? Is a continuing downturn in commercial property going to undermine the credit recovery? Are bad things still lurking in the banking system? And with governments critical to market confidence, will they tackle challenges in monetary policy, tax, regulation and trade without making mistakes big enough to upset the applecart?

Warren Buffett noted this week that a lot has to go right for Kraft to justify the price it has already put on the table for Cadbury. Yet if the British confectioner's share price is anything to go by, investors seem to expect a significantly higher offer to be forthcoming from the U.S. food group.

That in a way is today's markets in a nutshell. The foundations of a recovery are scarcely in place and the optimists are already looking for the lift to the new skyscraper's observation deck. They'll be lucky if they don't trip on some rubble while they wait.