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Are We in Another Bubble?

Nouriel Roubini, aka Dr. Doom, put himself back in the headlines last week by predicting the next great financial crisis. Roubini, as you know, became a household name for seeing just how severe the financial crisis would be, at a time when most economists were confident it would be confined to housing. While he believes we're finally pulling out of it, he says the next Big One will strike in six to 12 months.

Dr. Doom, relaxing between crises
What's worrying Roubini is an investment bet called the carry trade-made possible by the weak dollar and near zero interest rates in the U.S. In the carry trade, speculators borrow in the U.S. at ultra low rates and invest elsewhere-in emerging-market stocks and bonds, gold, oil, euros, whatever. As long as the dollar stays weak and U.S. rates low, it's a way of minting money, and every hedge fund and Wall Street trading desk in the world is doing it, according to Roubini.

The problem is, the dollar can't fall to zero. And U.S. rates won't stay low forever . When that trade reverses, panicky speculators trying to get out of the assets they bought with borrowed money will create what Roubini calls "the biggest co-ordinated asset bust ever."

Now, I actually don't want to get into whether Roubini is right. Felix Salmon, Reuters' economics uberblogger, believes him. David Rosenberg, the bearish economist at Canadian money manager Gluskin Sheff, has his own debt-driven doomsday scenario, which as of Monday now features a 13% unemployment rate in 2010. And after a 60% rally in the market over the past eight months, it's sensible to be worried that the markets have gotten ahead of the economy.

On the other hand, as Larry Swedroe points out in his CBS blog, Warren Buffett just bought Burlington Northern railroad-not the action of a man worried that the carry trade is about to hogtie the economy. Do you want to bet against Buffett? And James Paulsen, the optimistic chief investment strategist of Wells Capital, thinks all this anxiety is typical at the start of a sustained bull market.

As often happens in a volatile market, then, you're now torn between two highly plausible, totally contradictory views of the future. The key question is, what should you do about it-or about any extreme market forecast. And I'd answer this way.

  1. You have to remind yourself that the future is unknowable. Roubini is a smart guy, but he's also what decision experts are coming to call a "hedgehog," after Berkeley professor Philip Tetlock's great research on predictions, Expert Political Judgment. Hedgehogs are forecasters who tend to see the world through a single, unique lens (in Roubini's case, a persistently pessimistic one). When hedgehogs are right, they're spectacularly right. But they rarely foresee turning points.
  2. Think about where you'd want your money if Roubini is right. In the unwinding of the massive dollar short sales, Treasuries and cash equivalent investments like bank accounts would be the only safe places.
  3. Then, as you should do before you take anyone's investment advice, ask, "What if he's wrong?" In this case, if you put all your money into low yielding Treasuries and cash, you'd earn next to nothing in yield and you could miss an ongoing bull market in stocks. Bull markets don't come along all the time, and if you miss them, you miss the whole reason for owning stocks.
So, in the end, you have to hedge your bets. Keep enough money invested safely in money funds or the bank, along with a healthy dose of Treasuries: You want to make sure you can survive a Roubini-esque meltdown. If he really has you worried, put more into Treasuries and less into stocks than you ordinarily would.

Yes, we all wish we had listened to Roubini two years ago-just like we wish we had listened to Paulsen and Buffett in March. But you can't time the market, and you can't capture the profits of the past. Hedging your bets isn't the world's most exciting answer, but it's the only one that makes sense in an uncertain world.

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Photo courtesy of Flickr user Esthr, C.C. 2.0