Quotes of the Day

Fairy tales can hurt you only if you believe them. That's why the widespread conviction right now that the "Goldilocks economy" will prevail in 2007 is so worrying. Stock markets around the world have been rallying strongly because key global economic fundamentals are said to be not too hot, not too cold, but just right. Growth is solid, inflation is relatively low, energy prices are easing, interest rates are benign, and consumer spending is holding up, most importantly in the U.S. The assumption that investors seem to be relying on to justify the high prices they are paying for stocks is that this situation will last indefinitely.

But Goldilocks types are ignoring some macroeconomic realities that threaten this rosy outlook. We are now entering the sixth year of an unusually broad and long-lived global expansion. Thanks largely to easy monetary conditions in the U.S. and elsewhere, this expansion has resulted in the build-up of huge economic imbalances that are unsustainable over the long term. These include the U.S. trade and current-account deficits, the accumulation of $3 trillion in monetary reserves by Asian central banks, excessive debt growth and leverage around the world, and growing income and wealth disparities. A sudden, sharp reversal of any one of these imbalances could cause stocks to fall precipitously. The sell-off could be triggered by any number of lurking dangers—an adverse geopolitical event such as an act of aggression against Iran, say, or the implosion of a massively leveraged hedge fund, or a loss of enthusiasm for the popular but perilous yen carry trade, whereby speculators borrow money cheaply in Japan's currency and then use it to bet on higher-return assets around the world. If that rich source of global liquidity were to dry up, the impact would be far greater than today's sanguine investors realize.

Not only stocks are at risk. Because of the liquidity that has been sloshing around the world, prices for all kinds of assets have been soaring in recent years. Virtually anything intrinsically valuable or desirable—real estate, metals, art, vintage wine, collectible watches, classic cars—has shot up in price. This universal asset inflation has been feeding on itself. For example, individuals and institutions holding real estate have been able to use their appreciating properties as collateral in order to take on larger debts, thereby increasing their consumption and driving up asset prices even more. As a result, asset prices have been ballooning at rates far in excess of nominal GDP growth. I believe we're in the midst of the greatest asset bubble ever.

The problem with excessive monetary and debt growth is that it always leads to inflation in one sector of the economy or another. In the 1960s we had wage inflation, in the 1970s consumer price inflation, and now we are in the throes of breakneck asset inflation. But every type of inflation eventually ends. And when assets deflate, economic activity will suffer. Business slows, lenders call in their debts, companies go bankrupt—all of which is bad news for stocks, especially those that are priced as if risk no longer existed. Economic history is littered with periods of asset inflation that ended in tears. Just look at the bursting of the late-'90s tech bubble or the crash in homebuilder stocks that occurred when the U.S. housing market slowed last year.

What makes the current investment mania unique is that it's happening in every imaginable investment category. When the crunch comes, emerging markets in general could be hit hard, but those that have gone up the most—places like Latin America, India, Russia and China—are likely to fall the most. At times like these, investors should remember that, while buying during selling panics tends to yield superior returns in years to come, euphoric buying binges often prove a wise time to sell. In today's heady environment, I'd recommend building up cash positions, not least by lowering exposure to assets in overheated emerging markets. And if you must believe in fairy tales, try Little Red Riding Hood. That's the one in which the little girl is devoured by the wolf she failed to recognize before it was too late.

• Marc Faber