More bubbles that could spell trouble

Two weeks ago, two pieces of modern art sold for close to $150 million combined — one by Andy Warhol fetching just over $72 million and one by Mark Rothko bringing just over $71 million (both figures include commissions).
Both of these figures were close to double the pre-auction estimates of what the works would bring.
That suggests that a new art bubble has emerged. It seems to me that the last time there was a bubble in art prices was in the 1999-2000 period, at the height of the technology bubble.
Soon afterwards, the tech bubble burst, with nasty short-term consequences for the economy.
Perhaps art bubbles are an early warning sign of an overheating economy.
We already have had one bubble burst. The housing bubble has popped, seemingly with only modest damage to the economy.
Yes, consumers seem to have cut their spending in April, judging by the sales figures reported by the auto companies and retailers, but the economy still seems too strong to slip into recession.
So everyone can relax, right?
Other threats
Not so fast.
The economy may have survived the deflation of one bubble, but to my eyes, there are several more apparent in the economy which could cause significant damage if they pop suddenly, especially if a couple of them burst at the same time.
Besides the art bubble, the three remaining bubbles are:
• The private-equity/leveraged-buyout bubble, caused by too much money trying to get into too few private-equity deals.
Who says there is a private-equity bubble?
Warren Hellman, the private-equity pioneer, for one.
Last year, more than $273 billion in private-equity deals were closed, he told The Wall Street Journal this month.
“That’s clearly a private-equity bubble,” Mr. Hellman said.
Although he didn’t say it, the rate of deal making is up this year.
Many of these deals are taking place mainly because of the tremendous supply of liquidity available.
This liquidity is being supplied by the recycling of petrodollars, dollars recycled from China, and dollars from pension funds, endowments and foundations.
• The hedge fund bubble, also caused by too much liquidity — and by the belief that hedge funds, through the use of financial engineering, can generate risk-adjusted returns far in excess of those that other types of investment can achieve.
So far, hedge fund implosions haven’t caused significant financial damage, but in the case of Greenwich, Conn.-based Long-Term Capital Management LP, that was only because of the timely intervention by the Federal Reserve.
• The infrastructure bubble. This too is powered by the excess
liquidity sloshing around the capital markets.
What was a good idea pioneered by Macquarie Bank Ltd. of Sydney, Australia, now is being taken to possibly dangerous levels by imitators.
What are the odds that the economy can navigate the next two or three years without at least one of these three significant bubbles bursting, causing it to grind to a halt?
In the private-equity/leveraged-buyout and infrastructure areas, for example, some transactions no doubt will increase economic efficiency over the long run, but others serve largely to move around financial assets and liabilities.
Some of these transactions eventually will fail because of the excess leverage taken on.
Unknown factors
In addition, no one truly knows the extent of the derivatives exposure of major financial institutions, and even some corporations, as a result of hedge fund activities.
If a Long-Term Capital-sized failure occurred simultaneously with the collapse of one or two other hedge funds leveraged up with high derivatives positions, no one knows if the financial system could handle the stress.
What if two of these bubbles suddenly began to deflate at the same time?
The longer the current recovery goes — and it is getting pretty long in the tooth, by historic standards — and the longer the bubbles continue to expand, the greater the likelihood of a catastrophic failure in the foreseeable future.
It is something for all financial planners and advisers to keep in mind as they review the portfolios of their clients.
How well could the portfolios withstand a market collapse equal to, or worse than, that of 2001-02? How likely is such a collapse?

Related Topics: Just Thinking