The Markets: Popping The Echo Bubble By Gareth Milliams

There are only two questions that an investment adviser should ask himself when recommending an investment to a client. They are "why this particular fund/stock/bond?" & "what will happen if I buy it?"

Every time that we make changes to a portfolio it has a direct effect upon our clients wealth. An investment recommendation is a serious intellectual challenge and one which should be embraced. This is why the aforementioned pair of questions always need to be asked and answered.

It is also why I get frustrated when I see portfolios put together by incompetent advisers who then leave them unmanaged. All too often I see 'European Managed' and 'UK Performance' funds that are destined too fail but put into client portfolios only because the name sounds positive.

Everything in life has to have context, particularly investments. Investing in anything because historically it has performed is naive. Continuing to do so, despite evidence to the contrary is negligent and stupid. Once a decision has been made to invest, it has to be reassessed, continually with context. We are, after all subject to the principles of cause and effect.

Presently, we are in the midst of a gold bull market. Gold's growth is partly a result of investor uncertainty in the financial markets but mainly due to the debasement of the US dollar.

Gold is a traditional hedge against dollar weakness but also a bastion against inflation. Yet we are presently still suffering deflation in the UK and US general economies. However, the weak dollar is creating a small island of inflation in the commodity markets. But the dollar cannot keep falling forever and it's reversal could (and probably will) herald a crash in asset prices.

It is a new bubble. How else can you explain declining oil consumption, yet a 132% increase in its price per barrel?

Nouriel Roubini said on CNBC last week, "There is a wall of liquidity…chasing assets,""Now we are in the mother of all carry trades. "It seems to me that this rally in oil prices is way ahead of the economy."

So what kind of Bubble is this? . According to Newsweek, it's an 'echo bubble'.

"It's a term economists use to describe the smaller bubbles that follow on the heels of major ones, usually after the authorities helicopter in loads of cash to patch up the first round of damage, setting the stage for a second round of easy-money-driven speculation. The phenomenon has been observed throughout history, from the British railway bubble of 1830 to the Saudi stock bubble of 2005. Edward Chancellor, author of Devil Take the Hindmost: A History of Financial Speculation, says, "Echo bubbles tend to be smaller and fade away faster than the first bubble." On average, they reach about 30 to 40 percent of the size of the original before bursting and sending market values back down to where they should have been all along, wiping out the gains of the echo, but generally not dipping back to the previous low. That implies a Dow falling to 7000 or 8000.

While new bubbles tend to build on entirely new market fads, echo bubbles generally retrace old territory. It's no accident that today's biggest price spikes are in assets like commodities (which peaked in 2008) and emerging markets (late-2007 peak). "The story of endless global growth, now driven by China and other key emerging markets, is a dream that dies hard," notes Ruchir Sharma, head of emerging markets for Morgan Stanley Investment Management".

Bad investment decisions are liable to be victims of the "law of unintended consequences" After all, nobody makes mistakes on purpose, but mistakes are made. It is the job of an investment adviser to reduce the probability of a mistake. For that reason alone, no investment strategy can be written in stone.

If this is an echo bubble and less face it, how can these markets justify their growth when unemployment is still rising, states as large as California are bankrupt and credit is almost impossible to get? The US and UK are in deflation yet gold which has a negative relationship with it, rises?

So we keep a vigil. We watch the markets.

Closely.