Thursday, April 12, 2007

Gong Show - Bubbles

I'm gonging bubbles this week because they grossly misallocate resources for a period of time and because many people are impoverished because of this misallocation.

From Wikipedia:

An economic bubble (sometimes referred to as a "speculative bubble", a "market bubble", a "price bubble", a "financial bubble", or a "speculative mania") is “trade in high volumes at prices that are considerably at variance from intrinsic values”. The intrinsic value is a theoretical calculation that aims at reflecting the fair value by taking into account hypotheses of future returns and risks.

The bubble is usually followed by a sudden drop in prices, known as a crash or a bubble burst. Both the boom and the bust phases of the bubble are examples of a positive feedback mechanism, in contrast to the negative feedback mechanism that determines the equilibrium price under normal market circumstances. Prices in an economic bubble can fluctuate chaotically, and become impossible to predict from supply and demand alone.

Economic bubbles are generally considered to have a negative impact on the economy because they cause misallocation of resources into non-optimal uses. In addition, the crash which usually follows an economic bubble can destroy a large amount of wealth and cause continuing economic malaise. A protracted period of low risk premiums can simply prolong the downturn in asset price deflation as was the case of the Great Depression in the 1930s for much of the world and the 1990s for Japan. Not only can the aftermath of a crash devastate the economy of a nation, but its effects can also reverberate beyond its borders.

Another important aspect of economic bubbles is their impact on spending habits. Market participants with overvalued assets tend to spend more because they "feel" richer (the Wealth Effect). Many observers quote the housing market in the United Kingdom, Australia, Spain and parts of the United States in recent times, as an example of this effect. When the bubble inevitably bursts, those who hold on to these overvalued assets usually experience a feeling of poorness and tend to cut discretionary spending at the same time, hindering economic growth or, worse, exacerbating the economic slowdown. Therefore, it is imperative for the central bank to keep its eyes on asset price appreciation and take measures to curb high levels of speculative activity in financial assets. This is usually by increasing the interest rate; that is, the cost of borrowing money.

When the bubble occurs in equity markets, it is called a stock market bubble. It is usually very difficult to differentiate a stock market bubble from an ordinary bull market except in hindsight.
The cause of bubbles is often disputed although some experts believe that the cause of bubbles can be explained by the "greater fool's theory." The greater fool's theory explains the behavior of a perennially optimistic market participant (the fool) who buys an overvalued asset in anticipation of selling it to another rapacious speculator (the greater fool) at a much higher price. The bubbles continue as long as the fool can find another (greater) fool to pay up for the overvalued asset. The bubbles will end only when the greater fool becomes the greatest fool who pays the top price for the overvalued asset and can no longer find another buyer to pay for it at a higher price.

Other experts argue that the cause of bubbles is excessive monetary liquidity in the financial system. Excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while central banks are implementing expansionary monetary policy (ie. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate. Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. The bubbles will burst only when the central bank reverses its monetary accommodation policy and soaks up the liquidity in the financial system. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Still others say that economic bubbles are mainly driven by the greed and irrational exuberance of overly bullish investors. They argue that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return. Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin. When investors feel that they are no longer well compensated for holding those risky assets, they will start to demand higher rates of return on their investments.
Due to this phenomenon, some regard bubbles as related to inflation and thus believe that the causes of inflation are also the causes of bubbles. Others take the view that there is a "fundamental value" to an asset, and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value. There are chaotic theories of bubbles which assert that bubbles come from particular "critical" states in the market based on the communication of economic factors. Finally, others regard bubbles as necessary consequences of irrationally valuing assets solely based upon their returns in the recent past without resorting to a rigorous analysis based on their underlying "fundamentals".

13 comments:

solipsist said...

Great post mohican.

Your blog has taken on a very nice shape too. Good work.

Anecdotally, I can tell you that discretionary spending is on the decline. Clients are evaporating, restaurants seem to be particularly un-busy, as do stores in general.

This bubble that we are most definitely experiencing will kill the economy. The glee and gloating of the (imaginary) nouveau-rich-in-RE, will turn to despair as sure as it will rain.

Jesse said...

mohican,

I re-iterate solipsist's comments. I enjoy reading and commenting here.

I'll Gong it but bubbles seem to be part of human nature (even in non-capitalist financial systems). Pick your battles.

mightymouse said...

I hope all this money hoarding I’m doing is going to pay off soon.

mohican said...

I agree jesse, as long as people have imperfect emotions and make imperfect decisions based on those emotions we will have asset bubbles.

I am still going to gong bubbles though because I think it is folly to go along with the crowd of koolaid drinkers. I don't think it will ever be fun to be a bubble-watcher but at least I won't impoverish myself, my family, and society because of my actions.

blueskies said...

This is usually by increasing the interest rate; that is, the cost of borrowing money.

me thinks something bad this way comes.....

M- said...

Just to add to Solipsist's anecdotal notes about store busyness, my dad's in the process of buying a new car. When he was in Richmond for a test-drive earlier today, he asked the young salesperson how busy it's been, and he indicated that it's been quite slow lately. (that comment got my dad excited, as it ups his negotiating position...)

Jesse said...

"...he indicated that it's been quite slow lately."

Not to be cynical, but this is an old sales tactic: get the buyer to feel compassion for poor struggling "Gil". It certainly ups the perceived negotiating position.

Warren said...

I agree Jesse. Car sales is a complicated business, and its not geared towards helping the buyer.. unless that was a new sales person.

Does anybody think the stock markets are inflated right now? Will a real estate crash effect the price of energy? Obviously house-building commodities will drop.

freako said...

Doublegonger. Great post. I wish we didnt' always have to learn these things once a generation or so.

It is usually very difficult to differentiate a stock market bubble from an ordinary bull market except in hindsight.

Yes. Since markets are forward looking, it is hard to determine which is which. A high aggregate P/E can mean bubble. Or it can just mean that earnings growth is expected to pick up in the future.

IMHO, one way of determing which is the case is to look at the amount of dumb money in the market. Also, in the case of RE, indirect effects of a bubble such as price compression. If there legitimate expectations of future growth, shrewd investors would not let compression occur.

The cause of bubbles is often disputed although some experts believe that the cause of bubbles can be explained by the "greater fool's theory."

Yep, but sometimes one worse. The fools are so oblivious that they actually believe appreciation will continue indefinitely. I think such a scenario can take a lot longer to turn around, as there are few people with their finger on the sell trigger. They need to be hit over the head first. More than once.

Other experts argue that the cause of bubbles is excessive monetary liquidity in the financial system.

Sometimes that is the case. But then, why is long term debt so cheap? If the long end popped up a couplde of percent, it'd be game over.

Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level

Again, I don't doubt that there is liquidity galore out there, but why is inflation (as measured by CPI) so low? If too much money chased too few assets, you'd think that the effects would manifest themselves in more areas than just RE and equities.

They argue that investors tend to extrapolate past extraordinary returns on investment of certain assets into the future, causing them to overbid those risky assets in order to attempt to continue to capture those same rates of return.

Yup, that is it in a nutshell. Extrapolation, pure and simple.

Overbidding on certain assets will at some point result in uneconomic rates of return for investors; only then the asset price deflation will begin.

Excellent point. Many speculatng investors fail to see the distinction between appreciation and fundamental return. If I say that rental income is low, they say "who cares, appreciation is double digits". Very flawed reasoning. A very hot potato. Whoever they sell the appreciated asset to has even worse yield and so on.

Others take the view that there is a "fundamental value" to an asset, and that bubbles represent a rise over that fundamental value, which must eventually return to that fundamental value.

Good view. But I emphasize that markets ought to be forward looking. I think many fundamental investors only look at earnings/rents statically. Some high P/E stocks deserve their high valuations.

I think bubbles are a bit like race car crashes. Overall it hurts people, screws up the race/market, but just as some secretly (or not so) long for a car crash, bubbles make for interestng times. If all markets were perfectly efficient all the time, I'd be pretty boring stuff.

freako said...

Will a real estate crash effect the price of energy? Obviously house-building commodities will drop.


House building commodities are already way down and affecting the B.C. economy.

Energy? A U.S. recession WOULD curtail demand. The stretch of high prices should be bringing increasing supples to market in the near future.

The unknown? Asia, and particularly China. If China continues growing, energy and other resources such as metals can maintan reasonably high price levels. But if the U.S. recession goes hand in hand with slowing of Chinese growth, commodites can deflate. That would be very bad news for B.C. The funny thing is that when I read about our hot economy rah rah rah, the talking heads go on like we should pat ourselves on the back, as if we just kicked ass in some sporting event. It just commodity prices for Christs sake. Easy come easy go. I read a book by Norwegian author Knut Hamsun once. It was partially about a fishing village who basked in undserved prosperity, and the resulting decadence did them in. On that topic, once the bubble pops, the blame game will be on. Fingers will be pointed everywhere but where should be - the mirror.

Detachable Cletus said...

"The unknown? Asia, and particularly China. If China continues growing, energy and other resources such as metals can maintan reasonably high price levels. But if the U.S. recession goes hand in hand with slowing of Chinese growth, commodites can deflate."

Doesn't China's currency peg to the US dollar prove their reliance on the US consumer?

I have heard it said that when you peg your currency to the currency of another nation, you are effectively adopting that nation's monetary policy.

Seems like China is giving up a lot of control over it's monetary destiny just to maintain a particular kind of relationship with one trading partner. That relationship must therefore be critical to them, no?

macho slob said...

China may be neck & neck with the US as the world's largest consumer, but their consumption includes grain and meat (to feed their 1.4 billion people), and coal and steel ( to manufacture cheap goods for the rest of of the world).

It will take at least another 10 years for the appetite of the Chinese and Indian middleclass to rival the enormous consumption by the US. Until that time, global economies will cotinue to be driven by the engines of the US.

To even hint that Western Canada will not be seriously affected by any turmoil in the US is ludicrous.

freako said...

"To even hint that Western Canada will not be seriously affected by any turmoil in the US is ludicrous. "

Yes, such viewpoints puzzle me. I can see people not having an opinion, or being worried about it. But not that there won't be an impact. It is beyond absurd.

The only way I can see an individual discounting bad news about the U.S. economy would be somebody who defends RE prices on general principle.

Bear: Price/rent multiple is out of whack.

Bull: Yes, rates are low.

Bear: That is already priced in and then some. Affordability is worse than ever at low rates.

Bull: Yeah, but our economy is hot.

Bear: Not for long, the U.S. economy is in trouble and resource demand will fall drastically.

Bull: That doesn't affect us. Everyone wants to live here, the Olympics are coming etc etc.

Absurd beyond belief. I can maybe see a well reasoned argument based on a serios of fortuitous and mitigating factors which can at least justify the POSSIBILITY of reduced impact. But these guys say it as if it is a fact, and without any thought or analysis whatsoever. Scary sh*t.